Balancing Act: Managing Exchange Rates in Developing Economies

-Edited & reviewed by Tommy Hodson

Exploring the challenges and strategies used by developing economies to influence their exchange rates

Introduction:

Managing exchange rates is critical for the economic stability of developing countries. This paper argues that reserve transactions, open market operations, and policy adjustments enable these economies to overcome challenges and achieve financial growth. By analyzing theoretical frameworks, the research demonstrates the effectiveness of macroeconomic tools in steering exchange rates toward sustained economic advancement.

The exchange rate has served as a nominal anchor for countries to build a monetary system. The most common forms of exchange rate systems are currency pegs and floating exchange rates (IMF, 2021). In a currency peg, the exchange rate is fixed to a single currency or a basket of currencies. In a floating exchange rate regime, the nominal exchange rate is allowed to adjust to market forces. Intermediate exchange rate regimes combine the economic and legal features of both fixed and floating systems (Ongdash et al., 2020). While these regimes are adopted by the majority of countries worldwide, they are especially prevalent in developing nations (Jurek, 2018).

Therefore, influencing the exchange rate serves similar policy functions across developing economies. Due to poor socio-economic conditions and weak financial institutions, many developing economies “are at a transitional stage, that is [to] not fully use all [economic] opportunities and advantages” (Ongdash et al., 2020). Ergo, D.E. have limited policy instruments and more challenges in realising economic goals as opposed to developed economies (Velasco, 1999). The paper posits that the exchange rate can be influenced by a few key policy goals, namely financial growth, price stability, inflation reduction, fiscal solvency, crisis prevention and management, and achieving long-term economic credibility.

Developing economies are faced with the dilemma of achieving necessary financial growth with relatively weak financial institutions; therefore, “identifying and tackling the sources of financial fragility is key for macro policymakers in developing countries” (Velasco, 1999). As a result, exchange rate stabilization has been conducted to facilitate foreign investment, low rates of inflation, and suitable conditions for economic activity (Ongdash et al., 2020). To achieve exchange rate stabilisation, follow a fixed exchange rate regime (Montiel, 2011). According to the Mundell-Fleming Trilemma, an economy cannot achieve a fixed exchange rate, free capital movement, and independent monetary policy at the same time (Montiel, 2011). If the developing economies are highly integrated with the global capital markets they will be left with an inflexible monetary policy, and inflexible monetary policy can prove to be detrimental to developing economies in curbing currency appreciation/depreciation pressures and responding to shocks caused by global financial integration (Montiel, 2011). Many countries have overcome this challenge by maintaining a significant stock of foreign exchange reserves as it can prolong the time during which an economy can pursue a domestic objective without having to give up an exchange rate peg (Montiel, 2011). If developing economies put restrictions on the flow of capital in and out of the country, they can achieve a stable nominal exchange rate. In such a scenario, “sustaining restrictions on such flows…[proves to be]…very problematic because of their diminishing effectiveness” (Jurek, 2018). The opportunity cost might be so significant that the growth rate can be lower in a country with fixed exchange rates, despite these countries having higher average rates of investment (Montiel, 2011). Moreover, “fixing the exchange rate may be a costly promise for the central bank to keep” and can undermine its credibility (Montiel, 2011). To solve this challenge, many economies use exchange rate bands: allowing the exchange rate to fluctuate within a specified range (band) (Montiel, 2011). This facilitates greater financial integration by allowing more capital to flow into the economy.

Another avenue to combat financial fragility is by facilitating trade. With relatively cheaper production and labour, developing economies can make their exports competitive under a floating exchange regime (Montiel, 2011). A major challenge that developing economies face is that there is no insulation of the domestic market from a volatile floating exchange rate. This can cause destabilising cyclical movement of the exchange rate and makes the currency vulnerable to currency crashes caused by large outflows/inflows (Velasco, 1999). Developing economies overcome this challenge by reducing the pass-through between nominal exchange rates and domestic prices (Velasco, 1999). One way of achieving this is through a dirty float. In a dirty float, the central bank intervenes in the free float of the currency to realise policy objectives. The central bank conducts the sale and purchase of foreign exchange reserves to alter the monetary base of foreign and domestic currencies and exert inflationary and deflationary pressures on the exchange rate (Mohanty and Berger, 2006). The central bank mandates commercial banks to increase/decrease the liquidity and mandatory reserves to influence domestic interest rates and control the money supply (Mohanty and Berger, 2006). Through these tools the central bank can limit international exchange rate pressures on domestic prices, subsequently reducing the pass-through. This provides D.E. “with the ability to use monetary and fiscal policies in a flexible counter-cyclical manner” (Montiel, 2011).

The reasons for influencing the exchange rate have been along the lines of price stability and financial growth, with occasional adjustments made for shocks. The only exception here is inflation targeting, which has inflation as a major policy goal. The challenges that these developing economies have faced in influencing their exchange rate range result in direct and indirect trade-offs between factors like price stability, inflation, fiscal solvency, credibility, monetary autonomy, and financial integration. The major ways in which developing economies have overcome these challenges have been through a) buying and selling of foreign exchange reserves, b) altering the capital flow and the money supply, c) short and long-run structural policy changes, d) expanding the monetary base, and e) changing the nature and volume of debt.

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