Countries devalue their currencies only when they have no other way to correct past economic mistakes - whether their own or mistakes committed by their predecessors.

The ills of a devaluation are still at least equal to its advantages.

True, it does encourage exports and discourage imports to some extents and for a limited period of time. As the devaluation is manifested in a higher inflation, even this temporary relief is eroded. In a previous article in this paper I described WHY governments resort to such a drastic measure. This article will deal with HOW they do it.

A government can be forced into a devaluation by an ominous trade deficit. Thailand, Mexico, the Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of the GDP. It can decide to devalue as part of an economic package of measures which is likely to include a freeze on wages, on government expenses and on fees charged by the government for the provision of public services. This, partly, has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic distress - it may be forced into devaluation. International and local speculators will buy foreign exchange from the government until its reserves are depleted and it has no money even to import basic staples and other necessities.

Thus coerced, the government has no choice but to devalue and buy back dearly the foreign exchange that it has sold to the speculators cheaply.

In general, there are two known exchange rate systems: the floating and the fixed.

In the floating system, the local currency is allowed to fluctuate freely against other currencies and its exchange rate is determined by market forces within a loosely regulated foreign exchange domestic (or international) market. Such currencies need not necessarily be fully convertible but some measure of free convertibility is a sine qua non.

In the fixed system, the rates are centrally determined (usually by the Central Bank or by the Currency Board where it supplants this function of the Central Bank). The rates are determined periodically (normally, daily) and revolve around a 'peg' with very tiny variations.

Life being more complicated than any economic system, there are no 'pure cases'.

Even in floating rate systems, Central banks intervene to protect their currencies or to move them to an exchange rate deemed favourable (to the country's economy) or 'fair'. The market's invisible hand is often handcuffed by 'We-Know-Better' Central Bankers. This usually leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the Pound Sterling debacle in 1992 and the billion dollars made overnight by the arbitrageur-speculator Soros - both a direct result of such misguided policy and hubris.

Floating rates are considered a protection against deteriorating terms of trade.

If export prices fall or import prices surge - the exchange rate will adjust itself to reflect the new flows of currencies. The resulting devaluation will restore the equilibrium.

Floating rates are also good as a protection against 'hot' (speculative) foreign capital looking to make a quick killing and vanish. As they buy the currency, speculators will have to pay more expensively, due to an upward adjustment in the exchange rates. Conversely, when they will try to cash their profits, they will be penalized by a new exchange rate.

So, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most of the emerging economies (also known as the Third World).

It looks surprising that only a very small minority of these states has them until one recalls their high rates of inflation. Nothing like a fixed rate (coupled with consistent and prudent economic policies) to quell inflationary expectations. Pegged rates also help maintain a constant level of foreign exchange reserves, at least as long as the government does not stray from sound macro-economic management. It is impossible to over-estimate the importance of the stability and predictability which are a result of fixed rates: investors, businessmen and traders can plan ahead, protect themselves by hedging and concentrate on long term growth.

It is not that a fixed exchange rate is forever. Currencies - in all types of rate determination systems - move against one another to reflect new economic realities or expectations regarding such realities. Only the pace of changing the exchange rates is different.

Countries have invented numerous mechanisms to deal with exchange rates fluctuations.

Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all the local currency in circulation is covered by foreign exchange reserves in the coffers of the Central bank. All, government, and Central Bank alike - cannot print money and must operate within the straitjacket.

Other countries peg their currency to a basket of currencies. The composition of this basket is supposed to reflect the composition of the country's international trade. Unfortunately, it rarely does and when it does, it is rarely updated (as is the case in Israel). Most countries peg their currencies to arbitrary baskets of currencies in which the dominant currency is a 'hard, reputable' currency such as the US dollar. This is the case with the Thai baht.

In Slovakia the basket is made up of two currencies only (40% dollar and 60% DEM) and the Slovak crown is free to move 7% up and down, around the basket-peg.

Some countries have a 'crawling peg'. This is an exchange rate, linked to other currencies, which is fractionally changed daily. The currency is devalued at a rate set in advance and made known to the public (transparent). A close variant is the 'crawling band' (used in Israel and in some countries in South America). The exchange rate is allowed to move within a band, above and below a central peg which, in itself depreciates daily at a preset rate.

This pre-determined rate reflects a planned real devaluation over and above the inflation rate.

It denotes the country's intention to encourage its exports without rocking the whole monetary boat. It also signals to the markets that the government is bent on taming inflation.

So, there is no agreement among economists. It is clear that fixed rate systems have cut down inflation almost miraculously. The example of Argentina is prominent: from 27% a month (1991) to 1% a year (1997)!!!

The problem is that this system creates a growing disparity between the stable exchange rate - and the level of inflation which goes down slowly. This, in effect, is the opposite of devaluation - the local currency appreciates, becomes stronger. Real exchange rates strengthen by 42% (the Czech Republic), 26% (Brazil), even 50% (Israel until lately, despite the fact that the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: it balloons and consumes 4-10% of the GDP.

This phenomenon does not happen in non-fixed systems. Especially benign are the crawling peg and the crawling band systems which keep apace with inflation and do not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the pegging basket. If the exchange rate is linked to one major currency - the local currency will appreciate and depreciate together with that major currency. In a way the inflation of the major currency is thus imported through the foreign exchange mechanism. This is what happened in Thailand when the dollar got stronger in the world markets.

In other words, the design of the pegging and exchange rate system is the crucial element.

In a crawling band system - the wider the band, the less the volatility of the exchange rate. This European Monetary System (EMS - ERM), known as 'The Snake', had to realign itself a few times during the 1990s and each time the solution was to widen the bands within which the exchange rates were allowed to fluctuate. Israel had to do it twice. On June 18th, the band was doubled and the Shekel can go up and down by 10% in each direction.

But fixed exchange rates offer other problems. The strengthening real exchange rate attracts foreign capital. This is not the kind of foreign capital that countries are looking for. It is not Foreign Direct Investment (FDI). It is speculative, hot money in pursuit of ever higher returns. It aims to benefit from the stability of the exchange rate - and from the high interest rates paid on deposits in local currency.

Let us study an example: if a foreign investor were to convert '100

<-- Previous | Next -->

If you found "How Do Other Countries Devalue Their Currencies?" interesting then check out our other :

Parking Facts and Other Articles

Parking.gs

Interesting :