Abstract
ABSTRACT Developing countries in general need flexibility and a sufficient number of instruments to prevent excessive volatility. Evidence does not support the orthodox belief that, with free floating, international financial markets will perform that role by smoothly adjusting exchange rates to their “equilibrium” level. In reality, exchange rates under a floating regime have proved to be highly unstable, leading to long spells of misalignment. The experience with hard pegs has not been satisfactory either: the exchange rate could not be corrected in cases of external shocks or misalignment. Given this experience, “intermediate” regimes are preferable when there is instability in international financial markets.
Highlights
Developing countries in general need flexibility and a sufficient number of instruments to prevent excessive volatility
The international adjustment mechanism can be undermined by many forms of speculative flows, which can be triggered by a combination of global conditions and domestic monetary policies and can lead to financial fragility and to real costs for the affected economies
The real costs of such form of speculation are enormous. It is pointed out how national and international policies need to address the major sources of imbalance by providing an institutional framework that would reduce the potential for speculative flows and promote coordinated efforts for exchange-rate adjustment and stable real exchange rates
Summary
The sources, sustainability and possible adjustment mechanisms of the widening external imbalances have been the object of one of the liveliest and most controversial economic policy debates of the past couple of decades. The swing from deficit to surplus in many crisis-stricken countries in Asia and Latin America was associated with huge devaluations of their currencies and large gains in competitiveness for their economies as a whole This nexus between the exchange rate and trade flows is acknowledged by those who believe that if the Chinese currency, the renminbi, were allowed to float freely, it would reduce the biggest surplus in the world and the biggest deficit at the same time. If the most important price for exports and imports, the real exchange rate, consistently moves in the “wrong” direction, there is hardly an easy way out of a protracted imbalance In other words, such “false” price movements should be avoided at all costs in order to allow the world economy to smoothly correct its global imbalances. This “false pricing” is exactly what happens in many financial markets of the world
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