Explain why a developing country’s decision to adopt a one-way peg may constitut

Question

Explain why a developing country’s decision to adopt a one-way peg may constitute a promise to prevent high inflation at home (a “currency anchor” arrangement). As part of your explanation, provide a BOP graph of a developing country Freedonia (THE HOME COUNTRY), pegging to the US$ (Freedonia’s currency is the free dollar, FR$). Starting with BOP balance, explain and show on your graph the results of rising inflation in Freedonia, BOP (+) or (-), central bank defense of the official exchange rate, and macroadjustment, including the effect on inflation in Freedonia.

Explanation / Answer

Analysts agree that "getting the exchange rate right" is essential for economic stability and growth in developing countries. Over the past two decades, many developing countries have shifted away from fixed exchange rates (that is, those that peg the domestic currency to one or more foreign currencies) and moved toward more flexible exchange rates (those that determine the external value of a currency more or less by the market supply and demand for it). During a period of rapid economic growth, driven by the twin forces of globalization and liberalization of markets and trade, this shift seems to have served a number of countries well. But as the currency market turmoil in Southeast Asia has dramatically demonstrated, globalization can amplify the costs of inappropriate policies. Moreover, the challenges facing countries may change over time, suggesting a need to adapt exchange rate policy to changing circumstances.

It looks at why so many countries have made a transition from fixed or "pegged" exchange rates to "managed floating" or "independently floating" currencies. It discusses how economies perform under different exchange rate arrangements, issues in the choice of regime, and the challenges posed by a world of increasing capital mobility, especially when banking sectors are inadequately regulated or supervised. The analysis suggests that exchange rate regimes cannot be unambiguously rated in terms of economic performance. But it seems clear that, whatever exchange rate regime a country pursues, long-term success depends on a commitment to sound economic fundamentals--and a strong banking sector.

The shift from fixed to more flexible exchange rates has been gradual, dating from the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s, when the world’s major currencies began to float. At first, most developing countries continued to peg their exchange rates–either to a single key currency, usually the U.S. dollar or French franc, or to a basket of currencies. By the late 1970s, they began to shift from single currency pegs to basket pegs, such as to the IMF’s special drawing right (SDR). Since the early 1980s, however, developing countries have shifted away from currency pegs–toward explicitly more flexible exchange rate arrangements. (See the table of exchange rate arrangements on pages 16 and 17.) This shift has occurred in most of the world’s major geographic regions.

Back in 1975, for example, 87 percent of developing countries had some type of pegged exchange rate. By 1996, this proportion had fallen to well below 50 percent. When the relative size of economies is taken into account, the shift is even more pronounced. In 1975, countries with pegged rates accounted for 70 percent of the developing world’s total trade; by 1996, this figure had dropped to about 20 percent. The overall trend is clear, though it is probably less pronounced than these figures indicate because many countries that officially describe their exchange rate regimes as "managed floating" or even "independently floating" in practice often continue to set their rate unofficially or use it as a policy instrument.

Several important exceptions must be mentioned. A prime example is the CFA franc zone in sub-Saharan Africa, where some 14 countries have pegged their rate to the French franc since 1948–with one substantial devaluation in 1994. In addition, some countries have reverted, against the trend, from flexible to fixed rate regimes. These include Argentina, which adopted a type of currency-board arrangement in 1991, and Hong Kong SAR (Special Administrative Region), which has had a similar arrangement since 1983.

Nevertheless, the general shift from fixed to flexible has been broadly based worldwide. In 1976, pegged rate regimes were the norm in Africa, Asia, the Middle East, nonindustrial Europe, and the Western Hemisphere. By 1996, flexible exchange rate regimes predominated in all these regions.

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