AMMAN, 21 July 2003 — The choice of exchange rate regimes involves tradeoffs between the advantages of fixing the currency and those of floating it. The main advantage of fixing a country’s exchange rate to the US dollar or the euro is that it maintains investors’ confidence in the currency, reduces exchange rate risks thus encouraging domestic saving and investment and discouraging capital outflow. Fixed exchange rate also reduces inflationary pressures associated with devaluation and provides a credible anchor for non-inflationary monetary policy, restricting financing the fiscal deficit by borrowing from the central bank or by arbitrary printing of the currency.
The major drawback of fixed exchange rate regime is the fact that such a system cannot be used to adjust for external shocks or imbalances. Countries following a fixed peg cannot implement independent monetary policy nor do they have the option of devaluating their currencies to make imports more expensive thus reducing their impact on the country’s balance of payment and/or give a boost to their exports of goods and services.
A fixed peg is also a fixed target for speculators. This has been the case in Egypt recently, in Argentina last year, and in Brazil, Turkey, and Thailand in the 1990s.
Most of the Arab countries have put in place fixed exchange rate regimes, whereby their currencies are either pegged to the US dollar, whether officially (Saudi Arabia, Kuwait, UAE, Bahrain, Qatar and Oman) or de facto (Jordan), or pegged to a basket of currencies where the euro is the dominant currency (Tunisia and Morocco). Other Arab countries have followed a middle of the way exchange rate regimes such as managed float against the dollar (Lebanon) or managed float against the euro (Algeria). Egypt adopted a floating exchange rate policy on Jan. 29, 2003. Since the early 1980s, the currencies of the Gulf countries have been pegged to the US dollar, yet these countries were not much affected when the American currency had greatly appreciated in value during the 1990s. On the contrary, this helped reduce inflationary pressures and boost the purchasing power of the average Gulf consumer.
The argument that currency depreciation is simulative, because it makes exports cheaper in international markets does not apply here. The Gulf countries export mainly oil, petrochemicals, aluminum, liquefied natural gas (LNG), steel and light consumer products among others. Most of these products are denominated in dollars and will not benefit from devaluation of domestic currencies.
Jordan chose to peg its currency to the dollar in 1995, at the rate of JD0.709 to the dollar. Although the JD/dollar rate is not officially fixed at this rate, however there is a de facto peg. This helped Jordan align itself to the exchange regimes of the Gulf countries with which it has close economic and trade ties.
A fixed JD/dollar exchange rate would remove currency risk, encourage the flow of savings and remittances of Jordanians working in the Gulf and boost foreign direct investment, tourism and exports of other services. Jordan’s main exports are phosphate, potash, cement and pharmaceutical products, all are priced in dollars and devaluation will not add to their price competitiveness in the export markets. Putting in place a fixed exchange rate has greatly mitigated any residual risk of devaluation that was still on the mind of savers and investors and made it possible for the government to lower interest rates on the Jordanian dinar much more than would have been possible otherwise.
Egypt followed a managed peg regime, up till July 2001, whereby the Egyptian pound was allowed to trade in a narrow range centered at 3.45 pounds to the US dollar. However, speculative pressure started building in late 1999 as the government failed to pursue a credible policy that would bring equilibrium back to the exchange market. The inconsistency between fixing the exchange rate and financing the fiscal deficit by borrowing from the central bank has added to currency pressure. The pound was devalued by 14 percent in August 2001 and a crawling peg was introduced centered at 4.6 pounds to the dollar with a 3 percent fluctuation bond.
The Egyptian government adopted a floating exchange rate policy on Jan. 29, 2003, which saw the rate of the Egyptian pound moving toward the black market rate of 6 pounds to the dollar. The Egyptian currency continued to drift lower reaching 6.70 pounds to the dollar in the black market before stabilizing later on. This forced the government to issue a directive to companies earning foreign currency to sell at least 75 percent of these revenues to state owned banks in the hope of stemming capital flight from the country. The central bank’s foreign currency reserves, currently at $14 billion, have fallen by more than 20 percent since 1999.
This directive sent the wrong signal to market participants who were expecting to see less rather than more interferences in the exchange rate market. While this regulation helped to increase the availability of foreign exchange at banks and may have reduced parallel market activity over the short-term, it did represent some form of capital control and restricted the forces of supply and demand. The concern here is that market participants, both individuals and corporations, will fear further interferences and may take anticipatory steps. Furthermore, over time the private sector can be expected to develop mechanisms that allow it to circumvent the current regulations thus negating their effect as had happened in other countries with similar rules such as China and Russia.
While there have been signs lately that the Egyptian pound is gradually stabilizing, nevertheless, only credible and consistent economic policy would help build confidence and dissipate lingering exchange rate concerns. The government need to remove all restrictions and allow the pound to float freely.
The foreign exchange market should be liquid and enough dollars should be given to banks to satisfy demand. Raising interest rates or defending a target exchange rate level through direct intervention will not succeed. Credible monetary policy targeting a specific inflation rate and the reliable availability of foreign exchange will eventually bring forth market stability.
Exchange rate crisis occurs when governments say one thing and do another. Having a fixed exchange rate regime is like putting the economy in a straight jacket. There is nothing wrong with that, as long as, there are no excesses. If governments overspend and deficits are financed through borrowing from the Central Bank, the jacket will become tight and cracks will start to appear. Remedial measures will then have to be taken, putting the economy on a strict diet of fiscal discipline, higher interest rates and additional liberalization and privatization deals to attract foreign capital. We learned from the Egyptian experience that imposing restrictions on repatriation of foreign exchange or introducing bureaucratic hurdles on exchange houses can actually make things worse.
It is recommended for countries with liberalized capital accounts to follow one of two extreme exchange rate regimes: Either to let their currency float freely, or to fix it to the dollar or the euro. Efforts to have a bit of both, whereby, the exchange rate is either floating but with various constraints, or is loosely pegged to another currency create the conditions for excessive speculation that could lead to financial crises. If the monetary preconditions of sound fiscal and banking practices are not there, fixed exchange rate regimes will also not succeed and could only delay the inevitable. In such case, a floating exchange rate regime would be a better choice because it serves as a safety valve to help release pressure generated by internal and external imbalances and by the monetization of fiscal deficits.
(Henry T. Azzam is chief executive officer at Jordinvest.)