Reform global exchange rate arrangements urges UNCTAD

Contends that large speculative capital flows distort exchange rates and perpetuate current account imbalances; Says regional cooperation can help reduce vulnerability of developing countries

A safe correction to the increasing imbalances overshadowing the world economy would be much easier with more appropriate global exchange-rate arrangements, a new UNCTAD report argues. Arbitrary exchange-rate shifts should be managed just as tariffs and export subsidies are, and in the absence of such controls, the report says, regional cooperation may provide developing countries with some security against abrupt corrections.

The Trade and Development Report 2007 (TDR) says that in recent years there have been several cases -- for example in Germany, Japan and Switzerland -- where current-account surpluses have been accompanied by a real depreciation of the exchange rate, rather than an appreciation, as conventional theory would predict. Such movements in the “wrong” direction tend to increase rather than reduce the underlying imbalances. The TDR finds that among economies with large current account surpluses, only China has experienced a slight appreciation of its real effective exchange rate, and thus a slight deterioration in its competitive position, as convention would expect.

According to UNCTAD, this paradox can be explained partly by so-called “carry trades”, speculative capital movements resulting from differentials in nominal interest rates that are not compensated by immediate exchange-rate adjustments. (This is also referred to as “uncovered interest rate speculation.”) Big institutional investors such as hedge funds are able to trigger an appreciation in the exchange rate of a country with a higher nominal interest rate by shifting financial assets from currencies with lower nominal interest rates. They thereby increase by themselves the return on their own investments. In this way, carry trades break the link between interest rate differentials and the risk of currency appreciation.

If financial markets systematically distort the competitive positions of nations and companies, policy intervention is unavoidable sooner or later, the TDR says. UNCTAD economists therefore question whether a regime of floating exchange rates is an appropriate instrument for avoiding excessive current-account imbalances. They also note that recent pressure on China to float its currency may be counterproductive, as interest rates in that country are still relatively low, so that the renminbi might actually depreciate, rather than appreciate. If that occurred, it would accentuate, rather than reduce, the related global imbalance.
In the absence of satisfactory multilateral solutions, regional monetary and financial cooperation can fill some of the gaps in global financial governance

The lack of appropriate global exchange-rate arrangements may cause exchange-rate instability and misalignments, especially in developing countries -- and that may damage their overall competitiveness, the TDR warns. It may also lead to “beggar-thy-neighbour” strategies that would jeopardize regional trade agreements. To avoid a fight for market share through manipulation of the real exchange rate, and to prevent the financial markets from driving the competitive positions of producers from different countries in the wrong directions, the TDR 2007 suggests a new international code of conduct.

Such a code of conduct should be a key element of the global system of economic governance. Since arbitrary changes in the exchange rate affect international trade in a similar way as tariffs and export subsidies, the report argues, such changes should be subject to multilateral oversight and disciplines just as trade policies are. Such a system would also help developing countries avoid overvaluation of their currencies, which in the past has been one of the greatest impediments to sustained growth.

In the absence of such an arrangement, developing countries need flexibility for managing their exchange rates and a sufficient number of policy instruments, including taxation of capital flows and foreign exchange market intervention, to prevent excessive volatility in the external sector, the report says. Several developing countries have also been seeking to reduce their financial vulnerability by accumulating large foreign reserves as a cushion against external financial shocks.
But a regional approach – rather than one limited to the national level – may be more effective in addressing the financial vulnerabilities of developing countries, the report says. In times of financial strain, regional mechanisms ¬– such as regional agreements on mutual credit and/or the pooling of part of the collective international reserves¬ – are better suited for rapid action than the existing multilateral institutions, since member countries have more effective ownership of such a system’s governance. Also, loans could be disbursed under conditions more appropriate to the specific circumstances.

As shown by the European experience, regional arrangements for exchange-rate management among countries with a high share of intraregional trade can be an important element in the process of creating a common market, the report says.

The European experience is of relevance for developing countries also because it demonstrates that effective cooperation in this area requires significant efforts directed at macroeconomic convergence, and demonstrates that it takes considerable time and political will to overcome the difficulties on the way to viable regional monetary arrangements. Moreover, it is of particular importance for developing countries that, distinct from the European case, the macroeconomic policies pursued in a regional framework are conducive to capital accumulation and growth, as was the situation with the most successful examples of economic catch-up in East Asia.

“Regional financial cooperation among developing countries may be one of the building blocks of an improved international monetary order,” the report says. In the absence of institutional reforms at the global level, regional arrangements could become an alternative source of financial support for developing countries. If, on the other hand, the international financial institutions are reformed to take into better account the specific needs of developing countries in different regions, the report says, they could serve as the central body of a decentralized international monetary system. Under such a system, regional funds would provide for the current financial needs of their constituents and the international institutions would function as a second-floor financing source and as a lender of last resort.