The Role of IMF and the Exchange Rate Regimes - Case Study Example

Currency and economic crises The role of I.M.F. and the exchange rate regimes Place Executive summary There is a constant question of international economics of what is optimal choice of exchange rate regime. The Second Amendment to the IMF’s Articles of Agreement has enabled the member countries to adopt the exchange rate regime of their choice (Articles of Agreement, 2011). However, due to the fact that countries are no longer need to attach their exchange rates to the IMF system, they select that exchange rate regime that best suits their needs, whether it is fixed or floating (Ghosh & Ostry, 2009). The exchange rate is the most essential monetary policy tool for the emerging economies, one of which is Argentina. Its chronic inflation and currency crisis cause the country to adopt six different programs at stabilizing domestic prices (Historical Exchange Rate Regime of Asian Countries, 2000). The fixed exchange rate was used to help the country to recover to the world level. However, due to the pressures of the external debts, reduction in the export price and the speculative attacks, all these programs failed, abolishing the regime, devaluating the Argentine currency or set the two-tie exchange market that allowed the country’s exchange rate for financial payments to float. Table of contents Executive summary…………………………………………………………………... 2 Introduction……………………………………………………………………………. 4 Literature review………………………………………………………………………..4 Exchange rate regimes in Argentina……………………………………………….5 Argentina’s experience with exchange rate regimes…………………………………. 5 Country risk analysis…………………………………………………………………………….6 Advantages and disadvantages of different exchange rate regimes……………...6 Collapse of the exchange rate regime……………………………………………………7 An appropriate exchange rate regime for Argentina………………………………….8 Linkage between exchange rate regimes and currency……………………..9 Conclusion………………………………………………………………………………10 References………………………………………………………………………………12 Introduction Economic history has emphasized the importance of credible mechanisms in the developing of monetary regimes with the focus on the general standard (Fausten, n.d.). Thus, the various regimes created a diversity of alternative arrangements by the extremes of fixed and flexible rates. Since economic outcomes are influenced by the structural characteristic of the national and international environment, the single exchange rate is placed as the main theme in all circumstances, which in the twentieth century are bounded by the close approximation to each of the fixed and floating rates. Ghosh, Ostry and Qureshi (2014) define the choice of exchange rate regime as a constant problem that the emerging markets like Argentina are facing today. Hence, countries should choose between their floats and the hard pegs such as monetary union and currency board. The following paper will discuss the experiences of Argentina with the exchange rate regimes and will represent the advantages and disadvantages of the exchange rates in this country. The paper will also discuss the most appropriate exchange rate regime and why certain regimes failed. The linkage between exchange rate regimes and currency will be discussed. Literature review The question of currency crisis is under the great interest of different scholars for years already. Here the exchange rate regime plays an important role in the models mentioned by the following authors. In order to discuss the selection of the exchange rate regime, it is necessary to employ the proper empirical studies that focus on the provision of evidence about the importance of the certain regime in the particular country. Thus, Grandes and Reisen (2005) discuss how the exchange rate regime influence the macroeconomic performance in Argentina, its investment, trade openness, capital flows and fiscal or institutional rigidities. Culp, Hanke and Miller (1999) speak about the currency board as the regime of Argentina that failed to be confident link to the dollar. The explanation for the failure to adopt a currency in Argentina was explained by the not appropriate conditions within the country. Edwards (2002) discussed the effect of the collapse of the currency board regime on the Argentinian economic performance. Truman (2002) argues about the rigid fixed exchange rate system can cause more harm than good, hence the author offers floating to be accompanied with a transparent regime of moderate exchange market intervention. Exchange rate regimes in Argentina Argentina’s experience with exchange rate regimes According to Grandes and Reisen (2005), currency boards were designed as monetary arrangements for British colonies and existed in Argentine until 2002. They consisted of the fixed exchange rates managed by the law and policy where the domestic money could only be issued by the foreign exchange, enabling monetary policy discretion removal from the government and the central bank. When Argentine established its currency board linking peso to gold, millions of its currency were outstanding, however, there was no gold reserves in that country. Hence, it has chosen no reserve backing for the outstanding fiat issue of pesos and due to the confidence that was increased by the currency board system, there appeared a rapid grew of pesos and convertibility was not threatened (Culp, Hanke & Miller, 1999). Argentine provided the regime that was based on the Convertibility Act that passed in 1991 by Congress (Grandes & Reisen, 2005). It gave the dollar legal status and assisted in deregulation of the economy and liberalization of the current and capital accounts. The foreign exchange regime in Argentine features a deviation from the strict currency boards and introduced the loss of a lender of the last resort of the connection with the currency board and use of the country provision of liquidity. The post convertibility macroeconomic regime in Argentina was characterized by the replacing of the currency board with the dual exchange rate regime that kept the exchange controls. The government unified the International exchange trade market letting the peso to float. Frenkel and Rapetti (2007) state, however, the local currency floating increased the price of the dollar and further led to the average fall in the real wages of almost eighteen per cent and the recessionary impulse. Despite the expectations, such social indicators as unemployment rates and the indices of poverty and indigence suffered from the additional deterioration. Then the situation became better with the growing of the average annual rate in seven and nine per cent surpassing the historical maximum level reached in 1998 only (Frenkel & Rapetti, 2007). Country risk analysis Despite the economics digestion of Argentina’s crisis implication, there is a possibility to extract certain lessons from such situation and conduct risk assessment. A super fixed exchange rate regime is not the solution to the macroeconomic problems of the country with the currency board as the best solution (Edwards, 2002). The currency board forces politicians to perform fiscal policies and is not able to ensure the long-term equilibrium. The most serious risk associated with the regime in Argentina throughout 2001 is the dollarized banking system that imposed ill-fated deposit freeze and exchange controls. There is a certain concern of whether the emerging markets would allow a foreign currency to dominate the deposits in the baking system on Argentina. The recession period for Argentina that has started at the beginning of 2014, however, placed its activity contract with the end of 2013, characterized by the household consumption and fall of real wages and lack of confidence among the population. Since the monetary policy has tightened since 2013, the government used its foreign currency reserves to limit the fall of the Argentina’s currency and to keep the exchange rate risk substantial and connected with the possible new debt default (Parks, 2014). Advantages and disadvantages of different exchange rate regimes Cavallo (2004) states that the advantages and disadvantages of the different exchange rate regimes can be evaluated with regard to the effect that the exchange rate has on the domestic prices. The change in exchange rate policy, however, brings complications if the economy solves its inflationary problem and faces competitive crisis. As to the crisis in Argentina in 2002, the importance of deterioration of the prospects of growth provoked a terrible destruction in the financial and property right of savers well-being (Labonte, 2004). Thus, Misra (n.d.) states that currency board that Argentina was following, was a substitute to the monetary policy rule for the undisciplined discretionary monetary policy, hence it eliminated the inflation bias for the later. The disadvantage of the currency board is that it has no ability to set monetary policy to other domestic considerations, while the fixed exchange rate will fix the trade of the country despite the economic difference between it and its trading partners. Since Argentina had the hard peg regime of the exchange rate, its high level of inflation, the monetary disorder and low credibility of the policymakers needed a strong anchor for the monetary stabilization. Thus, the advantaged of this regime was that it provided the country with maximum credibility for economic policy regime. It also facilitated the disinflation and was not prone to currency crisis. However, according to the Exchange Rate Regimes in OIC Member Countries (2012) the disadvantage of hard peg regime toward Argentina was that its central bank lost its role as lender of the last resort, it caused higher probability of liquidity crisis and lower seigniorage under the currency board. The exit from dollarization would be also difficult. Collapse of the exchange rate regime and reasons behind this collapse Truman (2002) states that Argentina’s experience over the last years has clarified some aspects of the fixed exchange rate regimes. Thus, its choosing of the particular type of exchange rate that was based on the stabilization regime, that led to the law guaranteeing the convertibility of one peso into the dollar and backed by the currency board type of the monetary policy approach. A few years later it caused a collapse of the regime, its banking system has integrated and the economic and financial costs were on the rise. The reason behind this collapse was that the convertibility was associated with the few years of growth despite that fact that economy contracted by more than eight per cent in the last years. Besides, the failure of Argentina’s economy to grow was determined by the political support for the policies which were necessary to maintain its exchange rate regime. Hence, it led to the devaluation and default of the regime. Truman (2002) also points at the country’s exchange rate to be not fixed, but hardened by the convertibility law, the currency board type of monetary arrangement and the absence of strategy. An appropriate exchange rate regime for Argentina Frankel (1999) considers that in the time when countries are highly integrated with each other, there is more opportunities to create the optimum currency area with the region in which there will be its own currency and own monetary policy. The advantages of fixed exchange rates enhance the degree of the economic integration and the flexible exchange rates diminish. Moreover, the main advantage of the floating exchange rate for such countries as Argentina will be the ability to follow the independent monetary policy which is in many ways weaker than that of the neighboring countries (Frankel, 1999). While in 1980 Argentina was prompted to adopt the currency board, it had a dramatic hyperinflation and had no credible monetary authority. However, since 1999 it became the model of price stability and obtained growth of rates. Despite such success, the country cannot fit well to the traditional optimum currency area criteria, since it is not slam or open, has high labor mobility or close correlation with the U.S. economy. The other point for discussion is that most developing countries such as Argentina are not able to make a good use of the monetary independence they have. Instead, the additional loss of the discretionary monetary policy for Argentina would be accounted to zero. Under the current regime of Federal Reserve Board raises the U.S. interest rates, the developing country interest rates rise more than one- for –one. Linkage between exchange rate regimes and currency Aşıcı (2008) considers that despite the country economic history and its exchange regime choice, there is evidence that proves each country cannot follow the specific regime for too long, hence, the transition across different regimes is common. While countries were advised to promote pegged regimes, some countries were also advised to utilize flexible exchange rate regimes for macroeconomic stability. The appearance of the currency crisis along with the vulnerability of the specific regimes is the main predispositions for transitions and new regime choice (Aşıcı, 2008). Countries with the foreign liabilities choose fix regimes because of their negative influence on the nominal depreciation of the currency. Besides, the financial dollarized countries are likely to fix their currency and do not float them, despite the indication of a positive correlation between well-being to peg and capital accounts (Edwards, 2006). The exchange rate regime impacts the real economy and the flexible exchange rates play a great role by smoothing output volatility. These are the essential incentives that are aimed to lessen foreign currency borrowing and enable the country to reduce its currency mismatches and deepen domestic financial markets (Gadanecz & Mehrotra, n.d.). However, financial development of the country and exchange rate flexibility develop and move along with each other, because the degree of exchange rate flexibility also depends upon the financial system’s stage of development. Hence, moving from the level of growth to its volatility enables flexible exchange rate to protect the economy from the negative impacts of external factors through the countercyclical role. Gadanecz & Mehrotra (n.d.) also state that the extreme exchange rate flexibility can become a source of real volatility due to the exchange rates to show the overshooting behaviour, if exchange rate movement displays a break of capital flows and causes a crisis. In addition, large exchange rate movements harden the influence of structural vulnerabilities in the economy, such as currency mismatches. Ihrig and Prior (2004) define the linkage between the crisis that touches exchange rates on the multinational companies. While their activities are associated with the instability in terms of foreign currency, any changes in conversion rates can negatively or positively impact their profits and reduce or increase mains. There is also a risk to do business on the international level, however. Therefore, the best way to reduce such risk is to monitor the changes, lock into the exchange rate for the fixed period of time by establishing a forward contract. In such a case, if the exposure estimates are correct, there will be a lot of benefits for business, such as purchase currency in advance. Multinational companies can limit exposure to volatility via derivatives, which enable the companies to see performing of overseas operations. Conclusion While fixed exchange rates have been the main factor in the major emerging market financial crisis, there appeared a lot of concerns of policymakers whether to use these rates or adjust them toward the countries with the open to capital flows. The belief of soft pegs to be more efficient than hard pegs and free floating have led to the common view of the countries to adopt the known bipolar view or the two- corner solution. In order to promote exchange stability and avoid competitive exchange depreciation, there was created the International Monetary Fund that was charged to guard the system if fixed but adaptable exchange rates. Therefore, the stability of system of exchange rates and in order to avoid manipulating exchange rates, each country should follow its advice (The IMF’s advice on exchange rate policy, 2006). For those countries open to international capital flows, pegs are not needed unless they are very hard, a wide range of flexible rate arrangements become possible and most countries’ policies take some account to the exchange rate movement. It is argued in the literature that flexible exchange rate regime is preferred to those of fixed. It is because the flexible exchange rate regime assists in insulating the domestic economy from external unfavorable conditions and enables the monetary authorities and countries to meet the unforeseen and fundamental needs. Many developing countries, such as Argentina prefer the built-in discipline of a fixed exchange regime and the low cost the system is used to result lower exchange rate. References Articles of agreement of the International Monetary Fund (1944) Washington, D.C.: International Monetary Fund, 2011 Aşıcı, A. (2008) Exchange Rate Regime Choice and Currency Crises, Equity and economic development, 15th Annual Conference Culp, C., Hanke, S. and Miller, M. (1999) The Case for an Indonesian Currency Board , Journal of Applied Corporate Finance, Vol. 11, N. 4 Edwards, S. (2006) The relationship between exchange rates and inflation targeting revisited, The National Bureau of Economic Research, Edwards, S. (2002) The great exchange rate debate after Argentina, North American Journal of Economics and Finance 13 Exchange Rate Regimes in OIC Member Countries, (2012) Organisation of 12slamic cooperation statistical, economic and social research and training centre for 12slamic countries Frankel, J. (1999) No single currency regime is right for all countries or at all times, National Bureau of Economic Research Fausten, (n.d.) Exchange rate regimes, International economics, finance and trade, Vol.1 Frenkel, R. and Rapetti, M. (2007) Argentina’s Monetary and Exvhange Rate Policies after the Convertibility Regime Collapse, Center for Economic and Policy Research Grandes, M. and Reisen, H. (2005) Exchange rate regimes and macroeconomic performance in Argentina, Brazil and Mexico, CEPAL REVIEW 86 Gadanecz, B and Mehrotra, A. (n.d.) The exchange rate, real economy and financial markets, Bank for International Settlements Ghosh, A. and Ostry, J. (2009) Choosing an Exchange Rate Regime, International Monetary Fund, Volume 46, Number 4 Ghosh, A., Ostry, J. and Qureshi, M. (2014) Managing the exchange rate: It’s not how much, but how, The Centre for Economic Policy Research Historical Exchange Rate Regime of Asian Countries, (2000) The Chinese University of Hong Kong Ihrig, J. and Prior, D. (2004) The Effect of Exchange Rate Fluctuations on Multinationals’ Returns, International Finance Division, Board of Governors of the Federal Reserve System Labonte, M. (2004) Fixed Exchange Rates, Floating Exchange Rates, and Currency Boards: What Have We Learned? CRS Report for Congress, Congressional Research Service Misra, A. (n.d.)Floating Rate, Currency Boards & Currency Basket Systems, International Finance, Parks, K. (2014) Argentina economy stages April upstick, fails to dispel recession fears, The Wall Street Journal The IMF’s advice on exchange rate policy, (2006) Issue paper for an evaluation by the independent evaluation office Truman, E. (2002) Fixed exchange rates. The lessons from Argentina, Interamerican Development Bank Daily Read More