Addressing currency swings

Addressing currency swings

The APEC finance ministers' concern over the yen-dollar rate volatility since March is fully understandable. The wild currency swings have been hurting APEC's developing members in Asia in particular due to their intensive linkages with the Japanese economy. Furthermore, Japan, besides being one of the world's largest economies, is now the world's single largest exporter of capital.

No matter whether the current movements are signs of short- term volatility, or longer-term misalignment, their impact is equally damaging. What makes the matter more frustrating is the fact that even countries, such as Indonesia, which has pursued prudent macro-economic policies, fall victim to the currency swings.

The exchange rate is one of an economy's most important relative prices, which determines the division of output between tradeables and non-tradeables and, consequently, the level of output and employment, as well as the strength of inflationary pressures.

A major deviation from a sustainable path in any exchange rate causes not only a wasteful shift of resources but also price uncertainty.

Fundamentally, the equilibrium exchange rate is influenced by a host of structural factors ranging from changes in the terms of trade, to changes in savings and investment propensities. However, with the increased mobility of capital and the intertwining of financial markets around the world, exchange rate movements are often dominated by expectations of future inflation, interest rates, the credibility of government policies, and political events.

The irony, though, is that the exchange rate volatility, which is often the spillover effect of the industrial countries' policies, is more damaging to the developing countries than to the developed ones. Because the financial markets in the emerging economies are not yet well developed, their importers and exporters are more exposed to foreign exchange risks. Further down the line, the volatility also raises reserves needs and complicates the task of economic management in the developing countries.

The problems for the developing countries are often exacerbated by the fact that while the financial markets throughout the world have increasingly become intertwined with each other, industrial countries often choose their macro- economic policies independently, without serious consideration of their impact on the world economy as a whole. Policy makers in the industrial countries often ignore the fact that the level and growth of demand in their own markets have direct implications for the developing countries.

True, when most countries decided to adopt the floating-rate system in the early 1970s, they believed that the system would enable them to achieve a viable balance of payments adjustment without undue constraints upon their domestic policies and would provide them with greater autonomy and independence in the formulation of macro-economic policies.

But such a belief turned out to be a fallacy. The market reality and studies by various multilateral agencies, such as the International Monetary Fund, showed as early as 1983 that a high- degree of coordination of macro-economic policies among the industrial countries is a precondition to a more stable floating rate system.

But we think such coordination will be difficult to achieve as long as the economic powerhouses, especially Japan and the U.S., continue to have divergent views about appropriate domestic policies and continue to adopt different attitudes toward the implications of their policies on the exchange rates and the international monetary system in general.

Japan's Finance Minister Masayoshi Takemura and U.S. Secretary of the Treasury Robert E. Rubin reaffirmed at a separate meeting in Bali on Sunday their commitment to continuing consultation and cooperation on exchange market issues. But as long as their commitment is not regarded as credible by the market, the yen and dollar exchange rate movements will continue to deviate from their economic fundamentals.

The exchange rate gyrations also are raising questions about the IMF tasks which, under the charter of its foundation, include the promotion of exchange stability and maintenance of orderly exchange arrangements among members. Our impression so far is that while the IMF has been able to influence the policies of the countries (mostly developing ones), which use its funds, it is rather ineffective in influencing the policies of those industrial nations, which do not require its resources.