Mar 14, 1984

IMF STUDY ON EXCHANGE VOLATILITY SETTLES NOTHING.

GENEVA, MARCH 13 (IFDA/CHAKRAVARTHI RAGHAVAN) – At the GATT Ministerial meeting of 1982, and in the months leading to it, the problems of exchange rate fluctuations, and the U.S. policy of benign neglect, became a major issue across the Atlantic.-

The Ministerial declaration, unable to solve it, referred the issue for study by the International Monetary Fund.-

The one year study, now submitted to the GATT Council and due to be published shortly by the IMF, provides no conclusive answer either way, and raises more questions than it has been able to answer.-

There are also a number of questions that the study has not addressed at all, as being outside its scope, including "the fundamental one whether policies are needed to achieve greater exchange rate stability and if so, what those policies should be".-

"The considerations to be taken into account in managing the evolution of the International Monetary System" it says "go beyond its implications for trade flow, although this is an important one".-

The study deals largely with the exchange rate variability among the seven major Industrial countries.-

While the impact of this on the "environment" within which other countries have to plan their policies are covered, the study itself notes that the additional variability resulting from actions of countries outside the major seven industrial countries is not explicitly considered.-

The study notes that for the most parts the developing countries have maintained some form of pegging arrangements for their currencies.-

The uncertainty in their nominal exchange rates has thus two components: variability in the rate at which they peg to the numeraire currency or composites and the variability in the relationship between the numeraire and the other major currencies in world trade.-

In terns of competitiveness, a further element of variability is added by fluctuations in relative price levels.-

But exchange rate turbulence has relatively greater adverse consequences for the developing than for developed countries.-

Since trade is less frequently denominated in domestic currencies, traders face a greater measure of uncertainty, especially because forward facilities are less readily available or more expensive.-

Also, when a developing country pegs its currency to that of a major trading partner and floats against the currencies of other industrial currencies, this creates a preference for bilateral trade with the country to which it is pegged.-

A tendency foregoes the benefits of multilateral trading relationships and causes a less than full exploitation of comparative advantage.-

Another potential disadvantage arises from the premium which variable exchange rates place on the responsiveness and flexibility in production and trade.-

This is more likely to leave poor countries and small firms at a relative disadvantage.-

Also, if debt is largely denominated in a single currency, as indeed is the case for most developing countries, its values relative to exports is likely to vary in response to exchange rate swings among the Industrial country currencies.-

These exchange rate fluctuations could therefore result in random changes in perceived creditworthiness of developing countries with potential adverse consequences for a stable level of capital inflows, the study notes.-

These and other issues, not addressed or mentioned, would also raise questions about the soundness of the exchange rate devaluation that the IMF invariably recommends to the developing countries as part of its "conditionality" for lending to them.-

The study itself admits that the analysis has revealed relatively little in the way of directly measurable adverse effects of exchange rate variability on trade.-

Part of the explanation, it suggests, may be due to the inadequacy of statistical techniques employed. But it does not believe that more intensive or sophisticated tests would show a greatly different result either.-

This, it says, is probably due to the difficulty of trying top separate the independent effect of exchange rate variability from the impact of other changes in economic environment.-

While in principle it would be desirable to measure that part of the exchange rate variability that was independent of, and additive to, the uncertainty already present as a result of volatility of other variables, "no satisfactory way of making such a measure has yet been proposed".-

If the exchange rate system is supposed to promote trade between countries but actually discourages useful exchange because of uncertainties, should there not be an alternative way of ensuring continuous equilibrium between supply and demand?

And, when exchange rate movements are reversible, and are clearly inconsistent with current account equilibrium, would it not be better to smooth such movement rather than permit temporary false price to distort the allocation of resources?

In posing these questions, the study notes that these issues are outside its scope.-

And, while the case for smoothening exchange rate fluctuations is strong in principle, there are considerable complications in practice, it says.-

Overall, the study says, the arguments and evidence analysed about exchange rate variability point to indefinite conclusions.-

Uncertainty inhibits economic activity: that much is clear.-

But that does not necessarily mean that exchange rate volatility of a relatively short-term character has a serious adverse effect on international trade.-

In the first place, economic agents react to the presence of uncertainty by seeking hedge mechanisms that allow such risks to be reduced.-

Secondly, exchange rate variability is only one dimension of the uncertainty associated with international transactions.-

More fundamentally, exchange rates, though an uncontrollable "given" to an individual transaction, are themselves determined by interacting supplies and demands for foreign exchange.-

It is the shifts in these that give rise to price changes of exchange rates. Thus, it is the factors that give rise to such shifts rather than exchange rate changes themselves (that are the consequences) that should be regarded as the basic cause of uncertainty, it adds.-

"Whether or not prolonged shifts in underlying conditions that cause departures from some medium-term trend in exchange rate relationships are harmful for trade, is a question that falls outside the scope of the present paper, and cannot be satisfactorily answered by the kinds of empirical tests surveyed here", the study adds.-