The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FEDERAL RESERVE HANK OF mAA 51971 0% SAN FRANCISCO Monthly Review In this issue Exchange Rate Reform ? January 1971 Exchange Rate Reform? . .. International monetary reformers aim at achieving limited flexibility within a basic framework of fixed par values. Editor: W illiam Burke MONTHLY January 1971 REVIEW Exchange Rate Reform? T he financial system which presently governs the international market. In this manner, it ab international transactions is based upon sorbs the fluctuations in market demand which fixed exchange rates for individual national cur otherwise could push the rate beyond the one- rencies. T he International M onetary Fund percent limits. Purchases are made with a country’s foreign- (IM F ), which administers these arrangements, was established by treaty among its member exchange reserves, which consist o f U. S. dollars nations shortly after the Second W orld War. and other convertible currencies, Special Draw Since its founding the IM F has presided over a ing Rights (S D R ’s ), gold and/or borrowing number o f changes in the details o f the inter rights at the IMF. Day-to-day exchanges are national-payments system, but the principle o f transacted in convertible currencies — usually fixed exchange rates has remained intact. N ow reform o f this basic element o f the system is U. S. dollars — and official transactions with other central banks or with the IMF itself are under consideration. executed with SDR’s, gold, IMF borrowing The fixed exchange rate rights or convertible currencies. The basic objective o f this system is to facili Under the Articles o f Agreement o f the IMF, the member nations o f the Fund have pledged to maintain, for spot transactions, the external value o f their currencies within one percent o f a spe cific par value. (Thus, rates are not rigidly fixed.) Other pledges in the convention include such things as convertibility or freedom from restric tions on buying and selling o f the currency. Although escape clauses in the Articles have permitted the currencies o f some nations (mostly less-developed countries) to remain inconvert ible, and some transactions to occur at other than official par value, the major trading nations gen erally adhere to the rules. As a result, the bulk o f world trade today occurs within a network o f fixed exchange rates. In most countries which attempt to maintain the par values o f their currencies, the central bank is responsible for controlling exchange rate fluctuations. The central bank keeps the market exchange rate within the one percent o f par allowed by the IMF by trading its currency in tate world trade by establishing firm values for individual currencies relative to one another, and by reducing the risk o f exchange-rate fluctua tion. Another objective is to avoid competitive FEDERAL RESERVE BANK devaluations, such as characterized the destruc tive trade policies o f the 1930’s. The IMF provides a framework for avoiding SAN FRANCISCO give the central bank more choices in the degree and timing o f its intervention. In addition, the extent o f exchange-rate movements could give competitive devaluations by requiring that coun a clearer indication o f the strength o f current tries consult with, and for major (and even some market trends and help guide policy decisions. Another alleged shortcoming o f the present minor) adjustments, obtain approval from the IMF. At the same time, the Fund can use its lending power to help a country losing reserves on account o f temporary disequilibrium in its system is its tendency to encourage currency speculation. W hen a country’s exchange rate falls to its lower support price and its official reserves external balance o f payments to avoid unneces sary devaluations. Devaluations that do occur continue to fall, the probability o f devaluation are theoretically limited to countries in "funda mental disequilibrium,’ ’ such that their current currency begin to look at the alternatives avail exchange rate is inappropriate for their long-run balance-of-payments position. increases. T o protect themselves, holders o f the able for temporarily shifting their funds, and non-holders begin to sell the suspect currency short. If there is no devaluation, the currency’s Judged in terms o f its objectives, the present exchange rate cannot rise by more than two per fixed exchange-rate system has been quite suc cent. On the other hand, if a devaluation occurs, the reduction is often as much as 10 or 15 per cessful. W orld trade has increased steadily, the major currencies have become convertible, and cent. The relatively low penalty for incorrect the number o f major currency adjustments has speculation under the present system, compared been relatively small. It is difficult to say just how much fixed exchange rates have helped to to the possible gains from speculation, rein forces speculative pressures once a currency gets attain these goals, because other economic condi tions and policies also have influenced interna tional payments, but the fixed exchange rate has been associated with the record, and many IMF members are reluctant to modify it. Nevertheless, discontent with the present rules is growing, and more and more authorities are advocating greater flexibility. into trouble, and thus complicates the central bank’s management task, even if devaluation Objections to fixed rates ultimately is avoided. Even greater problems can be caused by the reluctance to change par values. In principle, the IMF Articles permit a country to alter the official value o f its currency whenever it is in funda mental disequilibrium, but in practice many fac tors may combine to delay such changes. Experts The arguments for and against reform o f the may differ as to whether an existing crisis is due to a speculative run on the currency, a temporary fixed exchange-rate payments system are complex fluctuation in the external trade balance, or to and involve political as well as economic issues. the fact that domestic prices and costs are out o f However, most o f the current reform proposals concur in the judgment that present IMF rules are too rigid: one-percent fluctuation about par line with the country’s longer-term trade posi tion. In the latter case, devaluation (o r revalua tion upwards) is an appropriate action to restore is not enough, and par values tend to be defended too long. balance. This conclusion may be obvious after Under the present rules, policy choices open ments crisis, it is not always clear what the real problem is and whether a change in the par value to a central bank are limited. It must intervene 4 OF the event, but in the midst o f a balance-of-pay whenever the market price approaches the sup port prices on either side o f par, which means is appropriate. that it must manage its currency within a total mistakes in changing the par value o f a currency range o f only two percent. A wider band would cannot be reversed easily. In a crisis, the adjust- Unlike domestic monetary or fiscal policies, January 1971 MONTHLY REVIEW same; a change in the par value o f the currency creates difficulties that a government usually pre fers to avoid. Considerations such as these often have led governments to delay changes in the par values o f their currencies, thereby impeding effective management o f the domestic economy and dis torting patterns o f international trade. Major trading countries have been especially reluctant to change their exchange rates, and in many cases their efforts to defend unsuitable fixed exchange rates create problems for their trading partners as well as for themselves. Proposals for reform Am ong the reforms that have been suggested, ment in par value must be large enough to con vince the international financial community that the new level will hold, or else speculation will continue. Yet too large a change may have un desirable effects on the domestic economy. In general, devaluations help export-oriented industries, but they also apply upward pressure on domestic prices. The cost o f imported materi the ones now receiving serious consideration by the IMF would increase the degree o f rate flexi bility that is possible within the existing frame work o f "fixed” exchange rates. Proposals to modify the existing rules are discussed in the report, The Role o f Exchange Rates in the A d justment of International Payments, released by the IM F’s Executive Directors in September 1970. als used by domestic firms increases automatically as a result o f the devaluation, as does the cost of imported goods purchased by domestic consum ers. From a payments standpoint, both effects are good because both discourage imports. However, Prom pt adjustment of parities: One set o f proposals is designed to eliminate undue delays in changing currency par values. The object is to encourage more frequent, small changes in pref erence to infrequent major adjustments. It is if firms attempt to pass along their costs to con sumers in the form o f higher prices and consum ers attempt to preserve their real income posi tions by extracting higher wages, the inflationary forces set in motion can wipe out the balance-of- hoped that small adjustments in par values would be more acceptable to individual governments, and would avoid some o f the shocks to inter national financial markets which were associated with the large (10 percent plus) changes o f the payments gains from the devaluation. past. The IM F report suggests the possibility o f restrictive policies which a government may find amending its Articles o f Agreement to permit adjustments o f up to 3 percent in any twelve- difficult to implement. Instead o f confronting month period without prior approval from the these problems it may prefer to avoid, or at least Fund. T o be successful, devaluation usually implies postpone, devaluation with tariffs or administra tive controls on goods imports and capital ex ports. Revaluation (the opposite o f devaluation) also causes internal problems by shifting the bur den onto export industries and import-compet ing domestic industries. But the point is the This suggestion is one o f a group o f related plans discussed in academic and financial circles under the general name "crawling-peg.” A n other variant is to establish a link between ex change rates and certain economic indicators, say an average o f past market-exchange rates, to 5 FEDERAL RESERVE BANK SAN FRANCISCO produce small automatic adjustments. However, market during the period when the rate is float the Fund’s report specifically rejects any auto matic formula on the grounds that economic ing, but it does eliminate the need for a parvalue objective to be announced officially. indicators often respond to cyclical or temporary forces and could produce unnecessary adjust The IMF takes the position that a new par value should be established as soon as possible, ments in exchange rates. In any case, as a prac and that the usual IMF rules then should be tical matter it is unlikely that governments would be willing to give up discretionary control over reapplied. N o general or regular use o f floating exchange rates is implied. something as important as their currency’s ex change rate. The report also regards very small one, except that it involves continuous change par value adjustments as inappropriate, because in the Fund’s view they are not consistent with In a sense, this plan is a variation o f the first in the exchange rate for a brief period until a single rate is formalized, rather than a series o f discrete changes over a longer period. The aim the correction o f fundamental disequilibrium. (Some writers have suggested weekly, fractional is to encourage countries to avoid unnecessary percentage adjustments.) delays in changing the par value o f W id e r parity margins: The second set of proposals involves increasing the parity margins from their current 1-percent range about par value in order to increase the risk associated with speculation and thereby discourage speculative runs on currencies. This proposal not only would increase the costs to speculators from guessing wrong, but also would give a central bank more leeway in managing its currency. The IM F’s report suggests that members be allowed, at their option, to widen the intervention limits to 2 per cent, or at the most to 3 percent, on each side o f parity. W ithin this range, it is hoped the fluctua tions in the exchange rate would not have a dis turbing effect on trade. This proposal and the previous one are not mutually exclusive, and many international economists believe that the two should be combined. Tem porary floating exchange rates: The IMF report describes a third approach to pay ments adjustments their currencies. Another advantage claimed for the floatingrate adjustment is that it avoids giving specu lators a quick, clear profit, since the exchange rate moves gradually to a new level. Market pres sures help set the proper long-term par value and thus help reduce the possibility o f another crisis in the near future. Finally, permitting the ex change rate to float for a brief period may help to avoid the build-up o f a crisis atmosphere, which often is created by prospect o f a major par-value change. The German case A case study o f the temporary floating rate is provided by the Federal Republic o f Germany, which floated the deutschemark for about one month in late 1969. Foreign capital had poured into that country in anticipation o f an upward revaluation o f the deutschemark, and speculators had become convinced that the mark was sig as "temporary deviations nificantly undervalued in terms o f other major from par-value obligations.” This means having currencies and that it would be revalued. The a "floating” exchange on a temporary basis. The IMF envisages the use o f floating rates in cases flood o f short-term foreign funds created serious problems for the Bundesbank (Central Bank), when it is obvious that some change is needed, but the appropriate size o f the change is unclear. which already had permitted domestic interest rates to rise to record levels in an effort to control inflation in the booming German economy. On The market would be used to test the strength 6 OF o f pressures on the currency, and in turn to indi cate an appropriate new par value. This approach does not exclude central-bank intervention in the the one hand, the expansion o f the domestic money supply caused by the inflow o f foreign capital aggravated domestic inflation, but on the January 1971 MONTHLY REVIEW other hand, efforts to offset this expansion would ing exchange rate, no official par value is an push interest rates still higher, attract still more nounced and no official intervention limits are foreign funds, and negate efforts to maintain the official price o f the mark. established. The central bank may intervene to dampen particular fluctuations, but in general, The conflict between domestic aims and de shifts in market demand and supply determine the exchange rate. fense o f the external price o f the mark presented a difficult policy dilemma. T o make matters The arguments for and against the floating worse, a federal election was to be held on Sep rate are numerous. Advocates claim that a float ing rate removes the conflict between balance - tember 28, and a revaluation was expected soon afterwards. On September 29 the German gov ernment announced that it was abandoning its of-payment objectives and internal policies that attempts to hold the mark at its official price, too often results in both inefficient domestic poli cies and restraints on international transactions. and would permit it to float temporarily. On the other hand, critics argue that freeing the The deutschemark fluctuated until October 27, when the new government announced a new par value, 9-3 percent above the previous par (mea sured against the d olla r). By using the floating rate, the German authorities were able to get exchange rate may result in excessive fluctuations, which can disrupt external trade and finance, and spill over into internal economic disturbances. A case study o f the floating-rate system is pro through a difficult period. The formation o f a vided by Canada, which has permitted the Cana dian dollar rate to float since June 1970. This new government had taken two weeks, and dur ing that time, no decision was possible on such experiment provides an isolated example o f how floating rates can work in practice, and it under an important matter. The flexible rate enabled scores certain shortcomings o f the current fixed- the authorities to postpone announcing a new rate system. par value, while avoiding the strains o f defend ing the old par value in the face o f a massive The Canadian case capital inflow. During the time the deutschemark floated, the foreign-exchange markets functioned with out evidence o f excessive or disruptive fluctua tions — the major disruptive pressures occurred before the rate floated. The Bundesbank was a major influence in the market throughout the period, so that the exchange rate could hardly be called a market-determined rate. Moreover, at the outset, the government had made it clear that the floating rate was only a temporary expe Canada in 1970, like Germany in the previous year, was faced with a large trade surplus and a heavy capital inflow, which together resulted in C a n a d a a d o p ts flexible rate (for second time) in mid-1970 U.S. Dollars dient and that a fixed rate would be re-estab lished. This experience thus provided a very suc cessful test o f the third proposal before the IMF, a temporary use o f a floating rate. Rejected: flexible exchange rates The IMF report rejected the alternative which is the logical extension o f arguments for more flexibility — a completely flexible floating ex change rate as a permanent policy. W ith a float 7 FEDERAL RESERVE BANK OF SAN FRANCISCO a rapid build-up o f foreign-exchange reserves Canadian reserves benefit during May. Additional capital inflows seemed from heavy long-term capital flows in prospect because o f the usual seasonal upswing Millions of Dollars in tourist expenditures, and as a result o f Cana da’s comparatively successful efforts to control the rise o f domestic prices. On June 1st, the Canadian government elected to let the Cana dian dollar float rather than attempt to fix a new exchange rate immediately. Unlike Germany, Canada has permitted her exchange rate to fluctuate for more than seven months in a range o f U. S. $.96 to U. S. $.98. Supposedly the floating rate is a "temporary” deviation from the IM F Articles. It is under stood that Canada intends to restore a fixed par value once conditions indicate an appropriate level. However, the last time Canada had a tem porary rate, it was temporary for twelve years. Canada is not under the equivalent pressures that Germany faced from its EEC partners to fix a par value, and it may well let the rate float for some time longer. Its external economic position continues strong, and the government may not wish to set a new parity under these conditions and be tied to a rate too high for longer-term trends. In addition, Canada has already experienced a floating-rate system — an episode which left a background o f experience dealing with float ing rates and a considerable body o f opinion favoring the system. In Canada, unlike most other countries, commercial bankers and aca duced a balance-of-payments crisis in 1962. The Canadian dollar was fixed again in the interna tional rescue operation that followed. The several experiments cited above— Canada 1950, Canada 1970, and Germany 1969— oc curred in countries with undervalued currencies, in an environment o f major capital inflows and expanding international reserves. In each case, the flexible rate — or in Germany’s case, the transitional float — proved to be a successful device for revaluing the currency. (Less reassur ing is Canada’s attempt in 1961-62 to use a flex demic economists are found on the same side o f ible rate to push down an overvalued currency.) the argument advocating floating rates. Only the 1950-61 period provides a prolonged Canada let its dollar float in October 1950 under similar circumstances to today’s strong test o f market-determined rates, and it can be argued that even this is not a sufficient test o f a exports and capital inflows, and it was not until general system o f flexible rates. Moreover, much 1962 that it returned to a fixed rate. For most o f this period, the floating dollar worked well, and o f the Canadian success rests on Canada’s favor able economic situation: a strong economy with without the problems o f instability supposedly easy access to U. S. financial markets. The balance associated with this system. W hen the floating o f official and financial opinion still opposes the floating rate except for truly temporary circum rate was finally abandoned, the primary cause 8 the flexible rate using official reserves, which pro was poor stabilization policies rather than any particular failure o f the floating rate itself. The stances, such as Germany’s 1969 situation, and final blow was an ill-fated attempt to manipulate alternative by the IMF. the floating rate has been rejected as a regular January 1971 MONTHLY REVIEW Strengths of present rules Despite the fact that the IMF actually is study ing three specific proposals, there is considerable reluctance among the various central banks and in the financial community to modify the present rules. In brief, the principal arguments against any change is that the present system has worked well, judged both by the record o f growth in international trade and by the basic stability o f the world’s major currencies under the IMF rules. It is difficult to measure how much trade has been encouraged by the system o f fixed exchange rates, but on the second point, the record is clear — only 14 changes in the par value o f currencies in 16 developed countries have occurred since 1959. Furthermore, only ten countries moved independently; in the other cases, the countries were follow ing moves by a principal trading partner. The network o f fixed rates has held together over the past decade in the face o f con siderable strain in individual countries, and it can be argued, therefore, that the existing sys bulwark tem shows considerable stability. policies. against overly permissive domestic In the future, the prospect for the maintenance For many European countries, membership in o f par values is relatively favorable. The IMF has increased its ability to lend reserves to coun tries facing speculative and other temporary pres sures. The quotas o f its members have been in the European Economic Community poses prob lems with regard to more flexible exchange rates. The EEC requires close coordination o f national economic policies as part o f the process o f econ omic integration, and the general EEC view is that fixed rates are essential to its purpose, espec ially in such complicated areas as the agricultural agreements. Therefore, individual EEC countries creased to give it more lending capacity, and a new international reserve unit, Special Drawing Rights (S D R ’s ), has been created on top o f the previous reserve assets. In addition, the major industrial countries have negotiated reciprocal currency (or "swap” ) arrangements among their could not make much use o f greater flexibility, central banks, and between their central banks although a unified EEC currency, whenever it is created, could take advantage o f flexible arrange and the Bank o f International Settlements, to ments. provide bilateral credit lines. As for the widening o f the margins about par There is also the so-called "discipline” argu ity, there is concern that the greater exposure to ment. Many contend that the present system should be continued because greater flexibility could reduce incentives for countries to combat cessive and, therefore, disruptive for trade. In particular, forward exchange markets may not be losses through exchange variations could be ex internal inflation as vigorously as they do now able to absorb the greater demand for "covering” to avoid a forced devaluation. Supposedly, the trade transactions at the wider margins that have discipline imposed by fixed rates is an important been suggested. A 3-percent margin against a par 9 FEDERAL RESERVE BANK OF SAN FRANCISCO In their 1970 annual meeting, the Governors value set relative to the U. S. dollar actually could mean a 6-percent swing against a third cur o f the International Monetary Fund considered rency, if the first is at its upper limit and the the proposals discussed in the Executive Direc other is at its lower limit. Therefore, an apparent tors’ report, but took no formal actions on the minor widening o f the intervention limits about suggested reforms. Most probably, they realized par might have serious destabilizing conse that the arguments on this question cannot be easily resolved. The proposed reforms could have quences. Finally, some traditionalists doubt that the important effects on the international payments gain in flexibility from the proposed reforms would be sufficient to help in major exchange- But unlikely as it may be that any or all o f the rate crises, such as the British devaluation o f proposed changes will be adopted in the imme 1967 or the French devaluation o f 1969. These adjustments were caused by a combination o f factors, many o f which were domestic, and they the first time, the International Monetary Fund probably could not have been avoided even with greater exchange-rate flexibility. system, and therefore must be examined carefully. diate future, the important fact remains that, for has formally considered the question o f intro ducing greater flexibility in the fixed exchangerate system. Robert Johnston Publications Available W a ll Street: Before the Fall — (3 6 pp. 19 7 0 ). A description o f basic stock-market developments o f the past 15 years. The booklet analyzes the industry’s operational prob lems, the expanded role o f institutions, and the supply-and-demand considerations underlying general price trends. Silver: End of an Era — (32 pp. 19 6 9 ). Series o f articles on silver coinage, industrial developments, and silver mining in the West. Discusses the demonetization o f silver and the recent price upsurge in the silver market. C o p p e r — Red M etal in Flux — (60 pp. 19 6 8 ). Historical study o f copper mining with emphasis on the growth o f the Western industry. Explores copper markets and the out look for the future o f the red metal. C re d it — and C re d it C a rd s — (1 6 pp. 196 9 ). Report on bank credit-card plans and check-credit plans in use throughout the United States. Explores the role o f Western banks as leaders in this rapidly growing field. Publication Staff: Ray Mansfield, Artist; Karen Rusk, Editorial Assistant. ID Single and group subscriptions to the Monthly Review are available on request from the Administrative Service Department, Federal Reserve Bank of San Francisco, 400 Sansome Street, San Francisco, California 94120 January 1971 MONTHLY REVIEW W estern Digest Rates Continue to Fall Interest rates continued to decline in January, headed by reductions in both the Federal Reserve discount rate and the prime business-loan rate. Federal Reserve Banks cut their discount rate to 5J4 an<3 then 5 percent — the third and fourth quarter-point reductions o f the last two months. Major commercial banks meanwhile cut the rate charged their most credit-worthy customers to 6 percent. (The prime rate is now down 2]/2 percentage points from the peak o f a year ago.) Recent declines in these rates and in domestic money-market rates generally have created pressures on money markets overseas. So far in January, the French, Italian and Japanese central banks have reduced their rates, and central banks else where are under pressure to follow suit. Business-loan Demand Holds Up In December, large Twelfth District banks posted a $2-billion (4-percent) increase in total loans and securities. The $764-million increase in business loans, which was con centrated over the tax date, represented a gain o f more than 5 percent, double the rate o f expansion nationally. However, Western banks added relatively less to their securities hold ings than other banks did during December. On the deposit side, total time deposits grew at more than a 3-percent rate for an increase o f over $1 billion. This rapid rise was mostly due to a substantial inflow o f public time deposits, which more than offset a run-off in large negotiable C D ’s. Demand deposits adjusted, although increasing 41/ 2 percent, trailed the expansion rate at other large banks. California's Jobless Rate Rises California’s unemployment rate remained a full percentage point higher than the nation’s during December, edging up to 7.1 percent while the national rate was rising slightly to 6.0 percent. Most major California industries posted declines in payroll employ ment during the month. Construction, trade, transportation and the Federal government all suffered employment declines, while the manufacturing and state-local government sectors registered increases. Congress Approves Eisenhower Dollar Congress passed a bill in December to mint 150 million Eisenhower dollars with a 40-percent silver content. The 46 million ounces o f silver required for this operation have already been set aside, mainly from U. S. stockpile supplies. The silver market meanwhile continued to weaken in December, despite the general expectation o f a price rise follow ing the termination o f the Treasury’s silver sales in early November. Between that point and year-end, the price o f silver actually fell about 10 percent.
@FedFRASER