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.