5. External shocks and flexible exchange rates


5.1 Exchange rate flexibility

One question that arises as a consequence of the global economic crisis and the tendency toward currency overvaluation in some Pacific island countries is whether Pacific island countries with fixed exchange rate regimes would have been better able to cope with the recent series of external economic shocks if those countries had an exchange rate system that allowed for greater exchange rate flexibility.

Friedman50 thought it easier and quicker for the productive sectors of a small open economy to respond to negative external shocks under a flexible exchange rate system than under a fixed rate system. He argued that it is better for economic agents to adjust immediately to relative price changes resulting from a nominal exchange rate depreciation (under a flexible exchange rate regime), than to wait (with a fixed exchange rate regime) until imbalances in goods and labour markets worked to bring about the required relative price adjustments and structural changes.

Hoffman found that developing countries with flexible exchange rate systems are better able to cope with negative external economic shocks than are countries with fixed exchange rates. Hoffman found that a one per cent reduction in global GDP leads to an initial 0.67 percentage point reduction in output in developing countries with fixed exchange rates, compared to a fall of only 0.4 percentage points in developing countries with floating rate regimes51. Similar results are reported in recent IMF studies52 and in other studies.53

The evidence appears to suggest that developing countries with flexible exchange rate regimes are better able to absorb economic shocks (for example, external demand shocks, negative terms-of-trade shocks54 and natural disasters), and deal more effectively with high current account deficits and exchange rate risk55, than are developing countries with fixed exchange rates. However, empirical paradigms established by reference to the experience of developing countries as a whole may not necessarily be applicable to Pacific island microstates.56

When considering the cases for and against greater exchange rate flexibility in Pacific island microstates during the global economic crisis it is necessary to disentangle the effects of two separate external economic shocks. The first shock - the sharp international food and fuel price upsurge - contributed to higher inflation and to a rise in the measured real effective exchange rate, while a later shock - the global economic recession - contributed mainly to a lower demand for exports sourced from Pacific island countries (and in some cases lower remittances and tourism receipts as well).

5.2 The first shock: the international food and fuel price upsurge

The surge in imported inflation - the first economic shock during the economic crisis - was based narrowly on the prices of imported food and fuel.

If a Pacific island country is a net importer of food and fuel (for instance Fiji, Samoa and Tonga) then the rise in imported food and fuel prices would have contributed to observed higher general inflation (see Chart 1) and to the observed rise in the real effective exchange rate (see Chart 3). In this case the rise in the real effective exchange rate might have reflected, in part, a loss of measured price and exchange rate competitiveness, if for no other reason than that the cost of essential imports would have risen. In this situation real incomes and savings will fall. Policy makers in the Pacific could possibly decide to react to this external price shock using an exchange rate adjustment. They could, for instance, appreciate the nominal exchange rate57 in an attempt to offset the higher imported inflation: this could be at the cost of exacerbating the decline in competitiveness in the short run. Another option could be to depreciate the nominal exchange rate to undo the rise in the real effective exchange rate, improve competitiveness and stimulate exports (to offset lower incomes and lower foreign currency reserves due to the higher cost of imports): this would be at the cost of higher imported inflation going forward. Alternatively, the authorities could choose not to respond (to lost competitiveness and lower real incomes) and to not adjust exchange rates on the basis of an assumption that the surge in imported prices would soon be reversed.

Whether a widespread loss of price and exchange rate competitiveness arose for Pacific island exporters or not in the wake of the food and fuel price upsurge, and the likely extent of the downward adjustment in the real exchange rates needed to offset this, depends upon a number of considerations. These include:

  1. the extent to which the rise in inflation observed during 2007 and 2008 (see Chart 1) was due solely to higher imported food and fuel prices;
  2. the incidence of higher costs of imported inputs (for example, fuel) used to produce exports and to service tourism; and
  3. whether the observed rise in inflation also reflected higher domestically-sourced inflation (due, for instance, to domestic wage increases or strong credit growth and excess demand pressures) which worked to raise costs and export prices more generally.

This is a complex issue requiring further empirical analysis on a country-by-country basis before strong conclusions could be drawn. It seems likely, nonetheless, that the food and fuel price surge would have had significant adverse effects on competitiveness in some countries and contributed significantly to currency overvaluation. Greater downward exchange rate flexibility would have worked to counter and offset these developments.

Of course, if a country is a net exporter of food and fuel (Papua New Guinea for instance), some part of the observed rise in the real effective exchange rate during this period may not have reflected a loss of price competitiveness, but, rather, an improvement in the terms-of-trade.

5.3 A later shock: the global economic recession

The global economic recession - the third economic shock during the global economic crisis - directly contributed to falling exports. During the global recession, the foreign demand for some exports of the Pacific island countries has been volume-constrained58, due to a fall in foreign demand for the quantity of imports. Devaluation may not be successful in offsetting this constraint in the short run59.

For many Pacific island microstates, imports are concentrated in necessities (food and fuel and imported manufactured goods) for which the price elasticity of demand is thought to be relatively low.60 Crude oil is generally not produced in Pacific microstates, and so substantial direct import substitution by domestically produced fuel is precluded, at least in the short-term. Domestically sourced replacement possibilities for imports of rice and some other foods and manufactured goods may also be limited. Tropical agricultural-based exports are also likely to have low price elasticities in the short-run.61 To the extent that tourism relies heavily on imported inputs devaluation would cut both ways.

With external demand volume constrained, narrow production bases, high export concentration and inflexible economic stru
ctures, high import dependency, low short-run trade elasticities and slow supply-side responsiveness there is likely to be limited capacity for rapid import substitution, or substantially increased exports in the short-run, in some small Pacific islands states. To the extent this is the case, the ability of a more flexible exchange rate regime to act as a shock absorber, and to cause export and import substitution production to increase in the short run to absorb and offset the second shock - the global economic recession - would be limited.

However, looking beyond the short-term - the end of the global economic recession - to a time when foreign demand will no longer be so volume constrained, and resource allocation can be adjusted to take advantage of relative price changes, the devaluation (that would be permitted by a more flexible exchange rate arrangement) is likely to be more effective62 in raising the foreign demand for exports from Pacific island states63, assuming the devaluation is maintained.

Quite apart from price competitiveness impacts on exports and imports, greater flexibility in the nominal exchange rates in response to an adverse terms-of-trade shock, or other external economic shocks, can moderate the variability of income flows and lower economic volatility. Greater exchange rate flexibility may contribute to smaller fluctuations in export commodity tax and other tax revenues, less exchange rate intervention by central banks, lower volatility in foreign currency reserves, and lower variability in the liquidity of the banking system. Such greater nominal exchange rate flexibility in the face of a large adverse external economic shock is likely to involve earlier, larger and more volatile real exchange rate adjustment.64

There is greater independence in the conduct of monetary policy - and monetary policy can be applied more flexibly - under a floating rate regime than under a fixed rate regime. This greater monetary policy independence itself provides a separate, additional policy lever to help deal with external economic shocks.65

However, the more flexible floating exchange rate regimes are not usually associated with the lowest inflation outcomes66 and they do not appear to increase trade integration. Very substantially increased volatility of the exchange rate (for example, that level of volatility associated with floating exchange rates) would likely add to exchange rate risk for businesses, tourism and consumers. In small Pacific Island microstates the financial systems and exchange rate markets are generally not sufficiently developed to support highly flexible exchange rates. Shallow markets can lead to high exchange rate volatility but the sophisticated financial instruments and related hedging derivatives needed to hedge against volatile exchange rate movements do not exist, or are not readily available or widely understood. High volatility in exchange rates can lead to large movements in export and import values and in the balance of payments.

If the flexibility in the exchange rate is substantial the nominal exchange rate may no longer be effective as a nominal anchor and may need to be replaced by a monetary aggregate target or an inflation target, raising new and challenging issues for policy-makers.

In summary, and taking all considerations into account, it seems reasonable to conclude that downward adjustment of the exchange rate is likely to have been desirable for Pacific island countries attempting to deal with medium term structural trade weaknesses (such as the loss of export preferences suffered by Fiji, or the depletion of log export capability in Solomon Islands), the surge of food and fuel prices, and currency overvaluation. However, it is equally likely that, given the limitations of small financial and foreign exchange markets operating in the microstates, the very substantial short-term exchange rate volatility likely to be associated with a freely floating exchange rate is unlikely to be clearly beneficial at this stage of their development. As well, attempts to use a flexible exchange rate as a short-term shock absorber is unlikely to be very effective in offsetting short-term trade disturbances such as a substantial dip-down in exports associated with a global economic recession.

5.4 Greater exchange rate flexibility: options and resistance

Options for greater exchange rate flexibility67 (for island microstates with their own fixed exchange rates) could include changing the current basket of currencies used to value the currency; increasing the frequency of exchange rate adjustments; widening the band in which the pegged exchange rate moves; adopting a crawling peg68; introducing a managed floating rate regime; or allowing the currency to float freely.

As mentioned above, it is questionable whether a freely floating exchange rate would work efficiently in very small Pacific island microstates. In such environments the exchange rate could be prone to overshooting. Large single transactions could have significant effects on the exchange rate. There could be substantial uncertainty as to where a market determined exchange rate would settle.

Introducing greater exchange rate flexibility is likely to be more successful if implemented when reserves are strong and effective anti-inflation macroeconomic policies are in place. It could be unwise to opt for greater flexibility in exchange rates beyond that which could be supported by market developments, monetary policy and the institutional and political environment.

For countries with fixed (pegged) rate regimes, introducing greater flexibility in exchange rate arrangements - through more timely adjustments - may reduce the likelihood that a substantially overvalued exchange rate would develop.

Introducing, or widening, the adjustment band in a fixed exchange rate regime creates the option to use exchange rate adjustments to cope better with an external economic shock, while otherwise providing the benefits of exchange rate stability.

The reluctance of some Pacific island countries to embrace greater downward nominal and real exchange rate flexibility (when faced with adverse economic shocks, declining competitiveness and when the currency is overvalued) could reflect a number of influences, including the concern that, particularly with high import dependency on food and fuel and other necessities and limited capacity for import replacement, devaluation of the nominal exchange rate would lead mainly to higher inflation (and lower living standards for those on fixed nominal incomes and those facing poverty), rather than to economic restructuring and to a real output stimulus (despite some evidence to the contrary). Governments may have a preference to defend the fixed peg, gain policy discipline and credibility, and keep the fixed nominal exchange rate as a strong inflation anchor. There may also be uncertainty over whether devaluation would be successful in the short-run; a view that other influences determining competitiveness (for example, infrastructure, soil quality, quarantine regulations, distance from markets and market access, transport problems, high post-import storage and distribution costs, and land reform) may be more important than price competitiveness; and uncertainty as to whether foreign exchange and financial markets, and monetary policies, would be sufficiently developed to support a strong degree of exchange rate flexibility. Where external debts are substantial (Samoa and Tonga, for example), concerns may arise because foreign debt servicing costs will increase w
ith devaluation.

It is possible that there will continue to be a high level of unpredictable volatility in the currencies of different countries throughout the period of the global recession, and the recovery from it, and this volatility will create additional uncertainty and difficult trade-offs for policy-makers in Pacific island countries. The global economic crisis, and the rapid advance of some countries and the decline in others, may alter global structural relationships and longer-term equilibrium real exchange rates, complicating policy choices. Amid increasingly competitive global markets and considerable uncertainty, the main general objective for Pacific island countries going forward would seem to be to ensure that the real exchange rate remains around its equilibrium competitive level over time.

For those countries with a fragile balance of payments, exchange rate adjustments alone may provide only temporary relief, particularly if monetary and fiscal policies are not sufficiently tight, if inflation is not reduced and if the government does not address the structural problems underlying the deterioration in the balance of payments. Structural reform policies aimed at enhancing transport infrastructure, productivity, competitiveness and export diversification, as well as reducing the high dependence on imports with import replacement policies, is also required. Without accompanying structural reforms any adjustments to the exchange rate regime may be of limited value in promoting higher productivity and improved fundamental competitiveness. In ideal circumstances such structural reforms would precede or be introduced in tandem with any adjustments to the exchange rate or the exchange rate regime.

50 M. Friedman (1953), ‘The Case for Flexible Exchange Rates’, Essays in Positive Economics, Chicago University Press. Mundell also argues that a floating exchange rate provides greater protection against real external shocks (for instance, a fall in the demand for exports or a fall in the terms of trade). See R. Mundell, ‘Capital Mobility and Stabilisation Polices under Fixed and Flexible Exchange Rates’, Canadian Journal of Economics and Political Sciences’, 1963.

51 Longer term impacts are 0.7 percentage points under pegs and 0.56 percentage points under floats. See M. Hoffman, ‘Fixed Versus Flexible Exchange Rates: Evidence from Developing Countries’, Economica, 2007.

52 See R Ghosh and J Ostry, ‘Choosing an Exchange Rate Regime’, IMF, December 2009. See P. Berkmen, G. Gelos, R. Rennhack, T Walsh, ‘The Global Financial Crisis; Explaining Cross-Country Differences in the Output Impact’, IMF Working Paper, WP/09/280.

53 See Sebastian Edwards, ‘Flexible Exchange Rates as Shock Absorbers’, NBER Working Paper No. 9867, July, 2003. See also S. Vella, ‘Exchange Rate Strategies for Small Island Developing States’, Bank of Valletta Review, No. 32, Autumn, 2005. See C. Broda, ‘Terms of Trade and Exchanger Rate Regimes in Developing Countries,’ Journal of International Economics, 63(1), 2004. See R. Ramcharan, ‘Does the Exchange Rate Matter for Real Shocks? Evidence from Windstorms and Earthquakes’, Journal of International Economics, 73(1), 2007.

54 See Berg, Borensztein and Mauro, ‘Monetary Regime Options for Latin America’, Finance and Development, IMF, September 2003, Vol 40, No. 3.

55 Floating exchange rate regimes force borrowers to confront the existence of exchange rate risk, thereby reducing unhedged foreign currency borrowings. See L. Cespedes, R. Chang and A. Velasco, ‘Balance Sheets and Exchange Rate Policy’, The American Economic Review, 94(4), 2004.

56 See Imam, op cit, for an analysis of the unique characteristics of microstates.

57 Interest rates could also be increased as a complementary measure to assist in lowering inflation.

58 As distinct from being constrained by a decline in price competitiveness.

59 To counter the volume constraint devaluation would need to cause foreign importers to reduce orders from other countries and give preference to increased exports from Pacific island countries. Alternatively it would be necessary for Pacific island exporters to secure new foreign markets, including through production diversification.

60 In one study the long-run price elasticity of import demand for Fiji is estimated to be around 1. An increase of 1 per cent in foreign prices relative to domestic prices induces a 1 per cent fall in the demand for imports. This suggests that devaluation would leave the import bill unchanged. See P. Narayan and S. Narayan, ‘Estimating Income and Price Elasticities of Imports for Fiji in a Cointegration Framework’, Economic Modelling, 22, 2005.

61 For Fiji, export demand is thought to be price inelastic (-0.8 per cent) in the short-run. See S. Narayan and P Narayan, ‘Determinants of Demand for Fiji’s Exports: An Empirical Investigation’, The Developing Economies, XLII-I, March 2004.

62 The latest (November 2009) IMF Article IV Staff Report for Solomon Islands suggests that while the authorities are concerned about the low elasticity of imports, the historical experience suggests that exports are more responsive than imports to a devaluation of the currency, and that devaluation could, therefore, be a useful adjustment instrument. Round logs, which account for 70 per cent by value, are sold predominantly on the basis of contracts transacted in US dollars, and are not affected by changes in the Solomon Islands exchange rate (that is de facto pegged to the US dollar).

63 There are few published studies on trade elasticities in Pacific island countries. In the case of Fiji, the long-run own price elasticity for export demand is estimated to lie between -1.25 and -1.49, suggesting devaluation improves export performance in the long-run. See S. Narayan and P. Narayan, op cit. In another article the same authors find that a 10 per cent devaluation in Fiji increases output by around 3.3 per cent. See ‘Is Devaluation Expansionary or Contractionary? Empirical Evidence from Fiji’, Applied Economics, 2007, 39.

64 See IMF, ‘Choosing an Exchange Rate Regime’, op cit. Christian Broda found that faced with an external shock, floating exchange rate regimes had earlier and stronger real exchange rate adjustments than did fixed exchange rate regimes. Under a floating rate regime the real exchange rate fell quickly due to the fall in the nominal exchange rate. See C. Broda, &lsquo
;Terms of Trade and Exchange Rate Regimes in Developing Countries,’ Journal of International Economics, 63, 2004. For evidence of greater volatility of the real exchange rate in the flexible exchange rate system see M. Baxter and A. Stockman, Business Cycles and the Exchange Rate Regime: Some International Evidence, 1989, USA, Cambridge.

65 See S. Edwards, ‘The Determinants of Choice Between Fixed and Flexible Exchange Rate Regimes’, NBER Working Paper, 5756, 1996.

66 See S. Vella, op cit. In a sample of small island developing countries (including nine Pacific island states),Vella finds that over the period 1990 to 2002 inflation was highest in countries with flexible exchange rates (10.9 per cent) compared to those with hard pegs (2.5 per cent).

67 It is assumed here that a common regional currency is unlikely to be introduced in the Pacific region given an insufficient convergence in economic policies and economic conditions in different countries and the requirement to give up the policy autonomy needed to deal with one’s own terms-of-trade developments.

68 Under the crawling peg system, the exchange rate can be devalued frequently by small amounts calibrated to the difference between domestic inflation and the inflation rate in trading partner countries.