Countries devalue their currencies only when they have no 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. It is true that encourage exports and discourage imports of some extensions and for a limited period of time. As the devaluation is manifested in higher inflation, even this temporary relief is eroded. In a previous article of this article describes what governments use such a drastic measure. This article looks at how they do.
A government may be forced to devalue an ominous trade deficit. Thailand, Mexico, Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of GDP. You may decide to devalue as part of an economic package of measures is likely to include the freezing of wages, government spending and the rates charged by the government for the provision of public services. This in part has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic difficulties - that can be subject to devaluation. International and local speculators will buy foreign currency by the government until its reserves are depleted and has no money even to import basic foodstuffs and other necessities. Thus compelled, the government has no choice but to devalue and buy back dearly the change that has been sold cheaply to speculators.
In general, there are two known types of systems change: the floating and fixed it. In the floating system, the local currency is allowed to fluctuate freely against other currencies and the exchange rate is determined by market forces within a loosely regulated foreign exchange of national (and international) market. Such coins may not necessarily be fully convertible but some degree of free convertibility is a sine qua non.
In the fixed, rates are centrally determined (usually by the Central Bank or the Monetary Board which replaces the function of the Central Bank). The rates are determined periodically (usually daily) and revolve around a "bonding" with very small variations.
Life is more complicated than any economic system, there is no "pure cases".
Even in systems of floating exchange rate, central banks intervene to protect their currencies or to move them to a favorable exchange rate considered (the economy) or "fair." The market's invisible hand is often handcuffed by "we know better," central bankers. This often leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the collapse of sterling in 1992 and billions of dollars made by overnight arbitrageur-speculator Soros - both a direct result of that misguided policy and hubris.
Floating exchange rates are considered a protection against deterioration of the trade.
If export prices fall or import higher prices - the exchange rate is adjusted to reflect the new flows of currencies. The resulting devaluation will restore the balance.
Floating exchange rates are also good for protection against "hot" (speculative) foreign capital looking to make a quick profit and disappear. As you buy the currency, speculators will have to pay more due to an upward adjustment in exchange rates. On the contrary, when they will try to collect their benefits should be punishable by a new exchange rate.
Therefore, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most emerging economies (also known as the Third World).
It seems surprising that only a very small minority of these states have until one recalls their high rates of inflation. Nothing like a fixed interest rate (along with consistent and prudent economic policies) to quell inflationary expectations. The fixed rates also help maintain a constant level of foreign reserves, at least as long as the government does not stray from sound macroeconomic management. It is impossible to overestimate the importance of stability and predictability, which are the result of fixed exchange rates: investors, entrepreneurs and traders can plan ahead, protect themselves by hedging and concentrate on long-term growth.
Not that a fixed exchange rate is forever. Coins - in all types of rate determination systems - move against one another to reflect the new economic realities or expectations regarding such realities. Only the rate of change in exchange rates is different.
Countries have invented numerous mechanisms to cope with fluctuations in exchange rates.
Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all local currency in circulation is covered by foreign exchange reserves in the coffers of the Central Bank. All government and Central Bank alike - can not 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, rarely does and when it does, rarely updated (as is the case of Israel). Most countries peg their currencies to arbitrary baskets currencies in which the dominant currency is a "hard and good reputation" of currencies like the U.S. dollar. This is the case with the Thai baht.
In Slovakia the basket is composed of only two currencies (40% in dollars and the 60% DEM) and the Slovak koruna 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 slightly daily. The currency was devalued at a rate set in advance and made known to the public (transparent). A close variant is the "corridor" (used in Israel and some South American countries). The exchange rate is allowed to move within a band above and below a central parity that itself depreciates daily at a preset rate.
The default rate reflects a real higher expected devaluation rate of inflation.
It denotes the country's intention to encourage its exports without rocking the boat money. It also signals to the markets that the government is committed to controlling inflation.
Therefore, there is disagreement among economists. It's clear that systems have a fixed interest rate down inflation almost miraculously. The example of Argentina is important: 27% per month (1991) 1% a year (1997)!
The problem is that this system creates a growing disparity between the stable exchange rate - and the level of inflation lower slowly. This in effect is the opposite of devaluation - the local currency appreciates, becomes stronger. Real exchange rates strengthened by 42% (Czech Republic), 26% (Brazil), even 50% (Israel until recently, despite the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: balloons and consumes 10.4% of GDP.
This phenomenon does not occur in non-fixed systems. Especially benign are the crawling peg and crawling band systems which keep pace with inflation and not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the basket of attachment. If the exchange rate is linked to a major currency - the currency to appreciate and depreciate the major currencies. In a way the inflation of the currency most important is what matters through the mechanism of change. This is what happened in Thailand when the dollar strengthened on world markets.
In other words, the design of the system of pegging the exchange rate and is the crucial element.
In a crawling band system - the wider the band, the lower the volatility of the exchange rate. The European Monetary System (EMS - ERM), known as "The Snake", had to line up a couple of times during the 1990 and each time the solution was to widen the bands in which exchange rates can fluctuate. Israel had to do it twice. On 18 June, 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 type of foreign capital, countries are looking for. Not the Foreign Direct Investment (FDI). It's hot money, hot in pursuit of increasing returns. Its aim is to benefit from the stability of the exchange rate - and high interest rates paid on deposits in local currency.
Let us study an example: if a foreign investor are converted to 100,000 Israeli shekels DM last year and invest in a liquid reservoir with an Israeli bank - the finished earning an interest rate of 12%. The exchange rate did not change appreciably - so he would need the same amount of Shekels to buy back DEM. In his Shekel deposit he would have earned between 12-16%, all net profits, tax free.
No wonder that foreign exchange reserves of Israel doubled in the last 18 months. This phenomenon occurred throughout the world, from Mexico to Thailand.
This type of foreign capital expands the money supply (which is converted to local currency) and - when it suddenly evaporates - prices and wages collapse. Therefore, it tends to exacerbate the natural inflation-deflation cycles in emerging economies. Control measures such as capital flows, taxes are useless in a global economy with global capital markets.
Also deter foreign investors and distort the allocation of economic resources.
The other option is "sterilization": selling government bonds and thereby absorb the excess money or maintaining high interest rates to prevent capital flight. Both measures have adverse economic consequences, tend to corrupt and destroy the banking and financial infrastructure and are expensive while bringing only temporary relief.
When flotation systems are applied, wages and prices can move freely. Market mechanisms are trusted to adjust exchange rates. In systems of fixed interest rate, taxes move freely. The State, voluntarily relinquished one of the tools used in fine-tuning the economy (exchange rate) - must resort to fiscal rigor, tightening fiscal policy (= collect more taxes) to absorb liquidity and curb demand when foreign capital is flowing in
In the absence of fiscal discipline, a fixed exchange rate will explode in the face of decision makers either in the form of forced devaluation or in the form of massive outflows of capital.
After all, what is wrong with volatile exchange rates? Why should they be fixed, except for psychological reasons? West has never prospered as it does today in the era of floating exchange rates. Trade, investment - all areas of economic activity that is supposed to be influenced by exchange rate volatility - are experiencing a continuous big bang. That daily small fluctuations (even in a devaluation trend) are better than a big devaluation in restoring investor and business confidence is an axiom. There is no such thing as a pure floating rate system (Central Banks always intervene to limit what they see as excessive fluctuations) - also agreed that all economists.
That exchange rate management is not a substitute for good practice of macro and micro-economic and political - is the most important lesson. After all, a currency is a reflection of the country is legal tender. Stores all data about that country and its evaluation. A coin is a unique package of past and future, with serious consequences in the present.
A government may be forced to devalue an ominous trade deficit. Thailand, Mexico, Czech Republic - all devalued strongly, willingly or unwillingly, after their trade deficits exceeded 8% of GDP. You may decide to devalue as part of an economic package of measures is likely to include the freezing of wages, government spending and the rates charged by the government for the provision of public services. This in part has been the case in Macedonia. In extreme cases and when the government refuses to respond to market signals of economic difficulties - that can be subject to devaluation. International and local speculators will buy foreign currency by the government until its reserves are depleted and has no money even to import basic foodstuffs and other necessities. Thus compelled, the government has no choice but to devalue and buy back dearly the change that has been sold cheaply to speculators.
In general, there are two known types of systems change: the floating and fixed it. In the floating system, the local currency is allowed to fluctuate freely against other currencies and the exchange rate is determined by market forces within a loosely regulated foreign exchange of national (and international) market. Such coins may not necessarily be fully convertible but some degree of free convertibility is a sine qua non.
In the fixed, rates are centrally determined (usually by the Central Bank or the Monetary Board which replaces the function of the Central Bank). The rates are determined periodically (usually daily) and revolve around a "bonding" with very small variations.
Life is more complicated than any economic system, there is no "pure cases".
Even in systems of floating exchange rate, central banks intervene to protect their currencies or to move them to a favorable exchange rate considered (the economy) or "fair." The market's invisible hand is often handcuffed by "we know better," central bankers. This often leads to disastrous (and breathtakingly costly) consequences. Suffice it to mention the collapse of sterling in 1992 and billions of dollars made by overnight arbitrageur-speculator Soros - both a direct result of that misguided policy and hubris.
Floating exchange rates are considered a protection against deterioration of the trade.
If export prices fall or import higher prices - the exchange rate is adjusted to reflect the new flows of currencies. The resulting devaluation will restore the balance.
Floating exchange rates are also good for protection against "hot" (speculative) foreign capital looking to make a quick profit and disappear. As you buy the currency, speculators will have to pay more due to an upward adjustment in exchange rates. On the contrary, when they will try to collect their benefits should be punishable by a new exchange rate.
Therefore, floating rates are ideal for countries with volatile export prices and speculative capital flows. This characterizes most emerging economies (also known as the Third World).
It seems surprising that only a very small minority of these states have until one recalls their high rates of inflation. Nothing like a fixed interest rate (along with consistent and prudent economic policies) to quell inflationary expectations. The fixed rates also help maintain a constant level of foreign reserves, at least as long as the government does not stray from sound macroeconomic management. It is impossible to overestimate the importance of stability and predictability, which are the result of fixed exchange rates: investors, entrepreneurs and traders can plan ahead, protect themselves by hedging and concentrate on long-term growth.
Not that a fixed exchange rate is forever. Coins - in all types of rate determination systems - move against one another to reflect the new economic realities or expectations regarding such realities. Only the rate of change in exchange rates is different.
Countries have invented numerous mechanisms to cope with fluctuations in exchange rates.
Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all local currency in circulation is covered by foreign exchange reserves in the coffers of the Central Bank. All government and Central Bank alike - can not 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, rarely does and when it does, rarely updated (as is the case of Israel). Most countries peg their currencies to arbitrary baskets currencies in which the dominant currency is a "hard and good reputation" of currencies like the U.S. dollar. This is the case with the Thai baht.
In Slovakia the basket is composed of only two currencies (40% in dollars and the 60% DEM) and the Slovak koruna 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 slightly daily. The currency was devalued at a rate set in advance and made known to the public (transparent). A close variant is the "corridor" (used in Israel and some South American countries). The exchange rate is allowed to move within a band above and below a central parity that itself depreciates daily at a preset rate.
The default rate reflects a real higher expected devaluation rate of inflation.
It denotes the country's intention to encourage its exports without rocking the boat money. It also signals to the markets that the government is committed to controlling inflation.
Therefore, there is disagreement among economists. It's clear that systems have a fixed interest rate down inflation almost miraculously. The example of Argentina is important: 27% per month (1991) 1% a year (1997)!
The problem is that this system creates a growing disparity between the stable exchange rate - and the level of inflation lower slowly. This in effect is the opposite of devaluation - the local currency appreciates, becomes stronger. Real exchange rates strengthened by 42% (Czech Republic), 26% (Brazil), even 50% (Israel until recently, despite the exchange rate system there is hardly fixed). This has a disastrous effect on the trade deficit: balloons and consumes 10.4% of GDP.
This phenomenon does not occur in non-fixed systems. Especially benign are the crawling peg and crawling band systems which keep pace with inflation and not let the currency appreciate against the currencies of major trading partners. Even then, the important question is the composition of the basket of attachment. If the exchange rate is linked to a major currency - the currency to appreciate and depreciate the major currencies. In a way the inflation of the currency most important is what matters through the mechanism of change. This is what happened in Thailand when the dollar strengthened on world markets.
In other words, the design of the system of pegging the exchange rate and is the crucial element.
In a crawling band system - the wider the band, the lower the volatility of the exchange rate. The European Monetary System (EMS - ERM), known as "The Snake", had to line up a couple of times during the 1990 and each time the solution was to widen the bands in which exchange rates can fluctuate. Israel had to do it twice. On 18 June, 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 type of foreign capital, countries are looking for. Not the Foreign Direct Investment (FDI). It's hot money, hot in pursuit of increasing returns. Its aim is to benefit from the stability of the exchange rate - and high interest rates paid on deposits in local currency.
Let us study an example: if a foreign investor are converted to 100,000 Israeli shekels DM last year and invest in a liquid reservoir with an Israeli bank - the finished earning an interest rate of 12%. The exchange rate did not change appreciably - so he would need the same amount of Shekels to buy back DEM. In his Shekel deposit he would have earned between 12-16%, all net profits, tax free.
No wonder that foreign exchange reserves of Israel doubled in the last 18 months. This phenomenon occurred throughout the world, from Mexico to Thailand.
This type of foreign capital expands the money supply (which is converted to local currency) and - when it suddenly evaporates - prices and wages collapse. Therefore, it tends to exacerbate the natural inflation-deflation cycles in emerging economies. Control measures such as capital flows, taxes are useless in a global economy with global capital markets.
Also deter foreign investors and distort the allocation of economic resources.
The other option is "sterilization": selling government bonds and thereby absorb the excess money or maintaining high interest rates to prevent capital flight. Both measures have adverse economic consequences, tend to corrupt and destroy the banking and financial infrastructure and are expensive while bringing only temporary relief.
When flotation systems are applied, wages and prices can move freely. Market mechanisms are trusted to adjust exchange rates. In systems of fixed interest rate, taxes move freely. The State, voluntarily relinquished one of the tools used in fine-tuning the economy (exchange rate) - must resort to fiscal rigor, tightening fiscal policy (= collect more taxes) to absorb liquidity and curb demand when foreign capital is flowing in
In the absence of fiscal discipline, a fixed exchange rate will explode in the face of decision makers either in the form of forced devaluation or in the form of massive outflows of capital.
After all, what is wrong with volatile exchange rates? Why should they be fixed, except for psychological reasons? West has never prospered as it does today in the era of floating exchange rates. Trade, investment - all areas of economic activity that is supposed to be influenced by exchange rate volatility - are experiencing a continuous big bang. That daily small fluctuations (even in a devaluation trend) are better than a big devaluation in restoring investor and business confidence is an axiom. There is no such thing as a pure floating rate system (Central Banks always intervene to limit what they see as excessive fluctuations) - also agreed that all economists.
That exchange rate management is not a substitute for good practice of macro and micro-economic and political - is the most important lesson. After all, a currency is a reflection of the country is legal tender. Stores all data about that country and its evaluation. A coin is a unique package of past and future, with serious consequences in the present.
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