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Exchange rate policies of selected Asian countries: Coordinating monetary and exchange rate policies can help curb inflation

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1982
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Bijan B. Aghevli

A study of the exchange rate policies of seven Asian countries (India, Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand) in 1973–78 reveals that countries with higher rates of inflation pegged their currency to the U.S. dollar and those with lower inflation rates adopted a managed float. Since all seven countries faced similar rates of foreign inflation, the differences in their domestic inflation rates were mainly attributable to the differences in their monetary policies. The differences between domestic and foreign inflation in these countries were partially offset by the movements of their effective exchange rates. However, these countries were generally reluctant to undertake large adjustments in their exchange rates, even when there were substantial differences between domestic and foreign rates of inflation. Consequently, the real exchange rate (defined as the relative price of imported and domestic goods) of the high inflation countries appreciated while that of the low inflation countries depreciated.

The deterioration of the relative price of tradable goods in the high inflation countries resulted in a shift in aggregate demand in favor of tradable goods and in a shift in aggregate supply in the opposite direction, as domestic resources were channeled into the relatively more profitable nontraded sector. The consequent excess demand for tradable goods was reflected in a deterioration of the external position in the high inflation countries. Analogously, the improvement in the relative price of tradable goods in the low inflation countries resulted in a strengthening of their external positions.

This article is based on a study by the author published in Exchange Rate Rules: The Theory, Performance, and Prospects of the Crawling Peg, edited by John Williamson (New York, St. Martin’s Press, 1981).

Regimes

Prior to the breakdown of the Bretton Woods system in August 1971, most Asian countries pegged their exchange rates to their intervention currencies with prescribed margins. Indonesia and Thailand were pegged to the U.S. dollar; India, Malaysia, and Singapore were pegged to the pound sterling; and only Korea and the Philippines were floating. A description of the exchange rate regimes of the Asian countries since the generalized floating of major currencies is provided in Table 1. This description is based on “revealed” as opposed to “officially announced” policies. Thus, all those countries that pegged to an undisclosed basket are put into the category of managed float, except those cases when the fluctuations of the exchange rate, in terms of the U.S. dollar, remained within a margin of 2.25 per cent; those cases are classified as pegging to the dollar.

A comparison of the exchange rate regimes and average inflation rates for various countries reveals an interesting pattern. Countries with higher rates of inflation pegged their currency to the U.S. dollar and those with lower inflation rates adopted a managed float. Consequently, the effective exchange rates of those countries with higher rates of inflation depreciated along with the U.S. dollar (the effective rate is defined as the weighted average of the bilateral exchange rates). This effective depreciation, however, was not enough to offset the difference between domestic and foreign inflation for high inflation countries.

Table 1Exchange rate regimes of selected Asian countries, 1971–78
Exchange rate regimeInflation rate1

(In per cent)
IndonesiaU.S. dollar peg 1971–7817.1
KoreaManaged float 1971–73; U.S. dollar peg 1974–7816.1
PhilippinesManaged float 1971–74; U.S. dollar peg 1975–7810.5
ThailandU.S. dollar peg 1971–788.2
MalaysiaSterling peg 1971–72; managed float 1973–785.8
IndiaSterling peg 1971–74; managed float 1975–785.3
SingaporeSterling peg 1971–72; managed float 1973–784.5

Average annual inflation rate of the consumer price index between 1973 and 1978.

Average annual inflation rate of the consumer price index between 1973 and 1978.

Trends

The exchange rate had its major impact on the economy in the Asian countries through its effect on relative prices and resource allocation. In the industrial countries, exchange rate variability has often been viewed as a major source of instability in the money and capital markets. Consequently, there is a great interest in these countries on expectations about future spot exchange rates and on interest rate differentials. In the Asian countries, however, private capital movements are influenced more by political factors than by exchange rate variability and interest rate differentials. Moreover, because of the fragmentation of financial markets, the size of private capital flows is relatively small and capital movements are dominated by official transactions.

The exchange rate is generally regarded as affecting resource allocation through its impact on three sectors: the export, import-competing, and nontraded sectors. In the Asian countries being considered, prices for most import and export commodities are given and are, therefore, not affected by the exchange rate. So, the export and import-competing industries can be considered as a single sector that can be identified as the “traded sector.” The domestic price of traded goods is then determined by their price on world markets converted into home currency at the given exchange rate. In these countries, therefore, the exchange rate affects resource allocation via its impact on the relative prices of traded and nontraded goods.

The estimated trend and the index of variability for domestic prices, foreign prices, effective exchange rates, and the real exchange rate are given in Table 2 for the two periods corresponding to the pegged regime (1968–72) and to the flexible regime (1973–78). Based on this information, two types of comparisons are possible. First, interperiod comparisons can be made in order to discern significant changes in the pattern of variations in prices and exchange rates under the two regimes. Second, intercountry comparisons can be made to identify general patterns in the exchange rate policies of the Asian countries.

Table 2Trend and variability of output, prices, and exchange rates, 1968–78(Average annual rates of change, in per cent)
Output1Domestic pricesForeign pricesEffective exchange rate2Real exchange rate3
TrendTrendVariabilityTrendVariabilityTrendVariabilityTrendVariability
Indonesia
1968–728.38.95.73.11.4-10.74.1-4.96.8
1973–787.717.17.96.78.0-2.88.87.610.5
Korea
1968–7210.011.51.82.91.8-11.15.3-2.44.3
1973–7811.116.15.06.68.6-6.25.03.36.7
Philippines
1968–724.110.53.53.21.4-17.410.6-10.110.5
1973–786.610.57.27.27.8-3.63.4-0.33.2
Thailand
1968–727.11.61.63.41.5-2.72.4-4.41.5
1973–787.98.24.76.87.9-1.86.3-0.43.5
Malaysia
1968–726.21.61.23.41.2-0.10.8-1.91.9
1973–787.85.83.97.87.10.03.6-2.22.8
India
1968–723.63.92.33.81.1-2.22.5-2.11.9
1973–783.45.38.59.16.3-1.92.2-5.75.3
Singapore
1968–7213.41.21.52.02.20.30.7-0.63.4
1973–787.74.56.37.97.10.02.6-3.43.9
Sources: IMF, International Financial Statistics and Fund staff.

A measure of variability is not provided for output because these series are available only on annual basis.

The weighted average of the bilateral exchange rates.

The relative price of imports to domestic goods.

Sources: IMF, International Financial Statistics and Fund staff.

A measure of variability is not provided for output because these series are available only on annual basis.

The weighted average of the bilateral exchange rates.

The relative price of imports to domestic goods.

An examination of price movements in the two periods reveals that in each country both the level and the variability of domestic inflation were higher during the second period, providing apparent support for the conjecture that higher rates of inflation are associated with higher variability of inflation. This association, however, does not strictly hold across countries; the variability of inflation is not necessarily higher for higher inflation countries. Neither does there appear to be a relationship, interperiod or intercountry, between inflation rates and growth rates in gross national product (GNP).

The foreign rates of inflation affecting each of the Asian countries were very close to each other because the bulk of these countries’ trade was with the same industrial countries. The average foreign inflation was around 3 per cent in the first period and about 7 per cent in the second period. The fact that both domestic and foreign inflation rates for all countries were higher during the second period, relative to the first, is consistent with the argument that imported inflation contributed to domestic inflation in the Asian countries. However, the diversity of inflation rates among the Asian countries indicates that inflation also responded to other factors.

The effective exchange rate of each of the Asian countries depreciated over both periods (with the exception of Singapore whose rate appreciated slightly). In all cases the depreciation was higher during the first period when, although exchange rates were adjusted less frequently, the adjustments themselves were larger. This somewhat paradoxical result is particularly true for the higher inflation countries. During the first period their inflation rates were lower, yet the effective exchange rates were less stable; during the second period, however, their effective exchange rates depreciated with the U.S. dollar, but relatively little, because they were reluctant to devalue. The variability of effective exchange rates was in general higher during the second period.

The changes in the real exchange rate reflect the net effect of the changes in domestic prices, foreign prices, and effective exchange rates. During the first period real exchange rates depreciated in all cases, as the higher inflation countries devalued by more than the difference between their domestic and foreign inflation, and low inflation countries maintained a stable exchange rate. During the second period the changes in real exchange rates were dominated by relative price movements. Therefore, the real exchange rates of high inflation countries (Indonesia and Korea) appreciated; those of medium inflation countries (the Philippines and Thailand) remained relatively stable; and those of low inflation countries (India, Malaysia, and Singapore) depreciated.

Inflation and BOP determinants

Three types of factors can be identified as causing domestic inflation in open economies: structural, external, and monetary. Structural factors, such as the wage and price rigidities that are often a source of inflationary pressure in the industrial countries, are relatively unimportant in the Asian countries; because of the existence of surplus labor, the size and power of organized labor tends to be limited. Thus, for all practical purposes external and monetary factors are the main determinants of domestic inflation in these countries.

Domestic inflation is affected by imported inflation, directly through the price of traded goods and indirectly through the price of nontraded goods. The latter effect operates with a lag because as traded prices increase, supply tends to shift from non-traded to traded goods, while demand shifts from traded to nontraded goods; the consequent excess demand for nontraded goods causes their price to increase. Taking account also of the influence of domestic monetary expansion on inflation, the rate of change of domestic prices can be specified as a function of the rate of change of traded goods prices and the rate of change of money supply.

In addition to increasing demand for nontraded goods, an excess supply of money increases demand for traded goods and results in a deterioration of the balance of payments (BOP). This relationship is the focus of the monetary approach to BOP, which views the BOP as the main endogenous channel through which the excess supply of money is eliminated in an open economy. In some of the earlier literature in this area, domestic prices were regarded as exogenously determined for small countries, and monetary factors only affected the BOP. However, with the inclusion of nontraded goods into the analysis, part of the excess supply of money is spent on them, pushing domestic prices up, thereby changing the real exchange rate. The changes in the real exchange rate, in turn, affect the excess demand for traded goods and consequently the BOP position.

In order to examine the validity of these relationships for domestic inflation and the BOP, a causality test was devised, based on an extension of the direct method suggested first by Pierce and Haugh (1977). The results indicate that domestic inflation in each country was caused both by imported inflation and by monetary expansion, and that the BOP outcome was caused by domestic credit expansion and by the changes in the real exchange rate. Moreover, in all cases except India, the rate of monetary expansion contributed more than the imported inflation to domestic inflation. Similarly, in all cases except India, the changes in domestic credit were the primary factor contributing to the BOP result.

Role of exchange rate policies

Insofar as each of the Asian countries experienced a similar rate of foreign inflation and relatively small movements in their effective exchange rates, the diversity of their inflation rates could be attributed largely to differences in their monetary policy; in fact, an ordinal ranking of countries according to their rates of monetary expansion matches that according to their rates of domestic inflation (Table 3). In the case of low inflation countries, imported inflation was a significant factor contributing to domestic price movements. In the case of higher inflation countries, rapid rates of domestic monetary expansion were the major contributing factor.

Table 3Money, inflation, real exchange rates, and external reserves, 1973–78(Average annual rates of change, in per cent)
Monetary expansionDomestic inflationForeign inflationInflation differentialsReal exchange rate1Reserves (In months of imports)
Indonesia2817.16.710.47.63.8
Korea2716.16.69.53.34.1
Philippines2110.47.23.2-0.24.5
Thailand188.26.81.4-0.54.5
Malaysia175.87.8-2.0-2.26.5
Singapore124.57.9-3.4-3.46.9
India155.39.1-3.8-5.710.1
Sources: IMF, International Financial Statistics and Fund staff.

Annual rate of appreciation (in per cent); negative values denote depreciation.

Sources: IMF, International Financial Statistics and Fund staff.

Annual rate of appreciation (in per cent); negative values denote depreciation.

The exchange rate policies of the Asian countries resulted in movements in their effective exchange rates that partially offset the differences between domestic and foreign inflation rates. Those countries with inflation rates higher than their trading partners (Indonesia, Korea, the Philippines, and Thailand) effectively pegged their currencies to the U.S. dollar, allowing them to depreciate along with the dollar. Countries with inflation rates lower than their trading partners (India, Malaysia, and Singapore) floated their currencies, allowing them to appreciate against the dollar. In general, however, the movements of effective exchange rates in the various countries were relatively small, reflecting the reluctance of the countries to undertake large adjustments, even when domestic inflation rates were substantially different from foreign inflation rates.

This reluctance could partly be attributed to the political implications of an exchange rate adjustment, particularly when domestic inflation was high and fears existed that a devaluation would exacerbate inflationary pressures. Also, because of the uncertainties associated with fluctuations in bilateral exchange rates among the major currencies, a number of countries adopted a wait-and-see attitude. Moreover, the depreciation of the U.S. dollar partially masked the need for further adjustment of those currencies that were pegged to the dollar.

The relatively small adjustments of the effective exchange rates resulted in a striking pattern: an ordinal ranking of the Asian countries according to the difference between their domestic and foreign inflation identically matches their ranking according to the amount of appreciation of their real exchange rates. The reluctance of the authorities to undertake large adjustments in the exchange rate tended to lead to an overvaluation of the currency in high inflation countries and to an undervaluation in low inflation countries. (It should be noted that the movements of real exchange rates do not necessarily imply an overvaluation or undervaluation of the currency, because the equilibrium level of relative prices of the traded and nontraded goods could change due to structural factors affecting supply and demand conditions for these goods.) The amount of the appreciation or depreciation of the real exchange rate is proportional to the differences in their rates of domestic and foreign inflation, and to the length of the lag with which the exchange rate is adjusted. The relative strength in the external positions of the various countries was generally consistent with the movements of their real exchange rates during the sample period; the reserve-import ratios of the countries closely paralleled the degree of appreciation of their real exchange rates.

Coordination important

On the basis of the observed regularities between domestic inflation rates and the movements of the real exchange rates, some generalizations about the exchange rate and monetary policies of the seven Asian countries can be made. The medium inflation countries (the Philippines and Thailand), with inflation rates somewhat larger than those of their trading’ partners, maintained relative stability in their real exchange rates by pegging their currencies to the dollar. Although the stability of the real exchange rate could also be maintained by a managed float, it can be argued that pegging to the dollar was more suitable. The transactions in these countries are rather limited and the institutional framework—including trading mechanisms, forward markets, and the like—is undeveloped. The volatility of the foreign exchange market under a managed float could thus have been quite high.

Pegging to the dollar provided a strong element of stability to the system by allowing the holders of domestic currency to gain access to the services provided to the dollar by the world markets at low cost and with limited risk. So long as forward cover for the dollar was available, this access spared traders the risk of fluctuations in foreign exchange. Alternatively, the currency could be pegged to a basket of major currencies. The advantage of pegging to a basket is that it would reduce the risk associated with the fluctuations of major currencies. However, insofar as forward cover is often not available for the currencies of the developing countries, the cost of forward cover for the traders would be higher when the currency is pegged to a basket of currencies than when it is pegged to a single currency.

In the case of the high inflation countries, expansionary monetary policies, combined with an exchange rate policy of pegging to the dollar, resulted in a marked appreciation of the real exchange rate. To avoid this, monetary and exchange rate policies needed to be coordinated more closely. In the absence of less expansionary monetary policies, a more flexible exchange rate policy could have been adopted by implementing either a crawling peg regime or a managed float. However, under a managed float it is often difficult to distinguish between short-run random disturbances in the foreign exchange markets and the long-run underlying economic developments relevant to the adjustment of the exchange rate. Moreover, the operational demands of a managed float could strain the policymaking process, particularly in light of the inadequacy of the institutional framework and the shortage of skilled operators for the foreign exchange market. With a crawling peg the exchange rate can be adjusted periodically and systematically on the basis of different monetary policies and inflation rates, making the daily management of the exchange rate simpler.

In the case of the low inflation countries (India, Malaysia, and Singapore) the real exchange rates depreciated significantly from 1973 to 1978. Conservative monetary policies in each of these countries resulted in domestic inflation rates below those of the trading partners; under the managed float regimes, the effective exchange rates of Malaysia and Singapore remained stable while that of India depreciated, reinforcing the divergence between its domestic and foreign prices. As in the case of high inflation countries, it can be argued that in these cases as well, monetary and exchange rate policies could have been coordinated more closely to limit the depreciation of the real exchange rate. It is difficult to argue that these countries should have adopted more expansionary monetary policies, thereby accepting the higher inflation rates abroad. Consequently, more exchange rate flexibility would have to be provided to stabilize the movements of the real exchange rates. Given the institutional framework, which was similar to that in the high inflation countries (except perhaps in Singapore), a crawling peg might well have been more appropriate than a managed float for the low inflation countries as well.

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