Monday, July 6, 2009

Do Currencies Really Float, Do They Swim or Do They Just Sink at Different Rates?

I ask this question in this way since when we ask whether the rupee should be allowed to float, there seems an implied fear, and in some cases, hope, that it will immediately sink! That is the consensus opinion it seems to me, or at least it seems that is the major fear. That is a fear I think that is unfounded. I think the Mauritian rupee could turn out to be a strong swimmer, should it be decided to let it float!

We are living in a new banking, financial and trading world now or at least one in which the established consensus on how such business is conducted around the world is ending. The Global Financial Crisis, to me, means the end of an era in which low cost, export led growth often using exchange rate depreciation was the chosen economic model used around the world by countries to sell their goods/service to America, largely, and to a lesser extent Europe. That world no longer exists and hence our views of currencies must adapt.

Both Germany and China have used their explicit or implicit fixed exchange rate regimes to follow export-led growth, with their surpluses being recycled to fuel consumption and housing booms in the ‘deficit’ countries notably the US. With the unrelenting slowing down of the world economy, and the credit crunch leading to global deleveraging, this is no longer sustainable. In fact that model may have been one of the chief causes of the Global Financial Crisis. China is now desperately trying to boost domestic demand through an infrastructure-led fiscal stimulus. What will other countries like Mauritius do? Do we need to fundamentally review what currencies we benchmark the rupee against taking into account this post leveraged, post American/European consumer world that I believe we now live in? Remember just a few years ago and it was not really possible to envision much else.

So, when we say that floating the rupee could be dangerous we must not also ignore that we may be accumulating a lot of other dangers which surely and inevitably will impact us by using a fixed or aggressively managed floating regime.

I also think that the Mauritian economy is becoming more diversified and if we do succeed in our ambitions to be a true regional financial and business services we may be linking our currency management to EUROs or Dollars which may be wholly inappropriate to the diverse range of business flows that we are in fact serving and the range of economic actors involved in them.

If however we continue to believe that we should aggressively manage our floating rate then there are three aspects of exchange rate management that we and our policy makers must think about: i) the stock of FX reserves with which to manage the float; ii) the extent to which we use these reserves to stabilize the exchange rate; and iii) the extent to which we might also use interest rates to stabilize the exchange rates.

The stock of currency reserves for managing a float is like having a good, buoyant lifejacket.
A country that floats without regard for the level of the exchange rate will not need a lot of reserves to manage its exchange rate. The rate will move with the prevailing current. In contrast, countries which are not willing to let the exchange rate fluctuate need a large cushion of reserves to achieve this in extreme or persistent shock situations. But a big lifejacket may not make it easy to swim in one direction or the other when in fact that is better than floating around in crashing waves!

That then makes us ask how much should we attempt to manage exchange rates by intervening in the foreign exchange market? The exchange rate could be more volatile in a current period because of a large external shock leading us to intervene to keep the exchange rate within certain limits. But even this identification of a shock that demands our intervention could be difficult to undertake depending on how comfortable we are with the accompanying volatility of reserves. And how do we know when enough intervention is enough?

Of course, intervention in the foreign exchange market is not the only tool for managing the exchange rate. We can also affect it by tightening or loosening monetary policy, ie policy interest rates. This is more controversial. Tightening monetary policy will result in pressure for appreciation of the currency, and loosening monetary policy will result in pressures for depreciation. But interest rates are a blunt tool since they may be changing for other reasons such as inflation targeting, investor sentiment toward emerging markets, etc. Under a pure floating regime, we should be able to set interest rates independently in order to achieve whatever objectives we desire, and let the exchange rate absorb the shock except if we float with an inflation target to control economic demand.

So in summing up, a truly “free” floating FX regime requires the public along with policymakers to understand that, it is not, ultimately, Free. There is always a price to be paid, which is, perhaps, great volatility in the exchange rate, or at least less policy driven control of what the “proper exchange rate should be.”

We should also understand that aggressively Managing the float is not truly Cost free or a guarantee of business stability. Our level of FX reserves, and the hidden costs of controlling the level of volatility that we expose ourselves to and our level of inflation all can have major consequences which may be just as dangerous or distorting to our economy as Floating Freely.

But to me, I would not at all bet against Mauritius’ ability to cope, in fact swim strongly, in a more dynamic and floating environment. I think we may well have a good lifejacket to protect us if we decide to float. But we would need to ensure this is taken as a measured and deliberate choice at a time of our choosing.

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