Some economists believe that flexible exchange rate regimes are appropriate for the world economy and as a result for every country. For example, during the period 1972-1976, in which the flexible exchange rate regimes were in force commonly, international trade accelerated more compared to domestic economy. Thus flexible exchange rate regimes must be implemented in order to improve world trade (Chipman C.S. and Hindleberger, 1980).
Exchange rate policy has been one of the most important issues for developing countries especially since early 1970s. In 1970s, oil shocks affected not only developing countries but also developed countries, but due to the nature of developing countries high indebtedness, inflation, lack of diversification in exports etc. those shocks affected developing countries deeply. In industrial countries, exchange rate have been determined by market sources, but in most developing countries, it has been determined by the monetary authorities.
Models Of Nominal Exchange Rate Determination
Determination of nominal exchange rate is very important because it affects real variables. There have been a lot of debate on exchange rate determination but it is hard to find a model that is good in theory and proofed empirically. Quantitative policy analysts must have something to determine exchange rates in their empirical models, so they either have an exchange rate equation that more or less fits the data or simply impose some mechanism, but they make little pretence that they have solved the riddle of exchange rates.
This approach states that the nominal exchange rate is determined by the real exchange rate. This idea is based on mainly ppp assumption. Purchasing Power Parity (PPP) theory argues that movements in exchange rates should reflect relative inflation movements.
Law of one Price: This approach states that if there are no tariffs, non-tariff barriers and transportation costs, then arbitrage should equalize the prices of identical goods across countries.
Absolute PPP implies that the change in the exchange rate should equalize the difference between domestic and foreign inflation. If this were the case, movements in exchange rates should be fairly small, as differences in inflation rates across countries are usually quite small. Because this is not the case, many economists have argued that steps ought to be taken to reduce exchange rate variability, and some have suggested a return to fixed exchange rates.
Relative ppp: Changes in the nominal exchange rate should reflect the differential of the price changes between the two countries.
This model considers the exchange rate as the relative price of two different currencies and it models the exchange rate to reflect the equilibrium conditions in the domestic money markets in two countries.
Exchange Rate Regimes
A. Flexible Oriented Regimes
1. Free float
In this regime, government has no direct effect on the currency markets. The market agents determine the rate. This regime provides elasticity. Monetary policy is very efficient. There is no need to keep large amount of reserve.
2. Managed float
Mainly the free market determines the rate, but central bank is ready to intervene to the market without anchor.
3. Floating within a band
This regime may cause speculative attacks in instable economies. The narrower the band the credibility of system is the less. The success of this system depends on reputation of government policies.
4. Sliding band
Monetary authority declares central parity and engages itself to that parity. This regime may be assessed as a kind of “floating within a band” in countries in which inflation exists.
B. Fixed oriented regimes
1. Crawling band
Central parity is adapted to the economic situation. Parity is determined according to mainly balance of payments. The difference between past inflation rates may be used to determine the parity.
2. Crawling pag
Nominal exchange rate is adjusted periodically according to some economic indicators. The band is very narrow. Market expectations are corrected according to this system. Credibility of policies is higher.
1. Fixed-but-adjustable Exchange Rate
Nominal exchange rate is fixed but central bank is not restricted by strict rules. Sometimes it may intervene to the market. This regime provides macroeconomic discipline, because expectation of risk decreases -especially exchange rate risk in foreign trade-. Devaluation chance causes elasticity in the economy.
On the other hand, if the devaluation rate is too high, that will cause uncertainty. Uncertainty increases the inflation expectations.
2. Currency Board
This is a fixed exchange rate regime with strict regulations. Monetary authority can issue the currency if only it has more foreign currency. That is, the more foreign currency a country has the more national currency it can issue. That means central bank is no more the last land of resort. Credibility of system (monetary and fiscal policies) is at maximum level because all the economic agents can foresee exchange rates in the future.
However, system is not elastic. If the country has a relatively small economy, external shocks can only be absorbed by unemployment and recession. Argentina implemented this regime in 1991 (Wise C., Roett R., 2000). Recent crisis in Argentina showed that this regime is extremely dangerous for those economies, which have unstable conditions.
3. Full ‘dollarization.
Country uses another country’s currency. That means its monetary policy is dependent on the other county. The credibility level is at maximum. Some of the Latin American countries implemented this regime.
On the contrary, system does not have elasticity. External shocks can only be absorbed by unemployment and recession.
DEBATES ON EXCHANGE RATE REGIMES
Flexible and fixed exchange rate regimes are two extreme systems, which can rarely be seen. On the other hand, there are many different regimes that lie between these two extreme systems. Views about right exchange rate regime differ widely. For example, Milton Friedman argue that free floating exchange rate is useful and Robert Mundell argued that a rate fixed to the gold standard is the best system (Frankel, 1996)
“…. the choice of appropriate exchange rate regime, which, for economies with access to international capital markets, increasingly means a move away from the middle ground of pegged but adjustable fixed exchange rates towards the two corner regimes of either flexible exchange rates or a fixed exchange rate supported, if necessary, by a commitment to give up altogether an independent monetary policy.” Lawrence H. Summers (2000).
“Intermediate solutions are more likely to be appropriate for many countries than are corner solutions” –Frankel (1999).
The debates on exchange regimes mainly focus on two aspects of regimes. First one is “the credibility” and the other one is “the elasticity”. This paper will mention the right exchange rate regime for Turkey with the help of these two terms. Credibility is the ability to foresee the future economic trends. Elasticity is the ability to absorb domestic and foreign economic fluctuations. All of the regimes are assessed in terms of “credibility” and “elasticity”. These two aspects can also be explained through two extreme exchange rate regime implementations. According to Ozdemir (2000), “In the free floating exchange rate regime, there is no central Bank intervention…. Thus, this regime results in elasticity. In the fixed exchange rate regime, policy makers can not implement independent monetary policy, but causes high credibility”.
The main argument in favor of hard pegs rests on the need to make monetary policy credible. If you cannot build credibility for monetary policy at home, then you can presumably import it by fixing the value of your currency to a hard-money country. The other important reason that leads many to advocate hard pegs is their ability to induce discipline – whether fiscal or monetary. Fixed rates induce more discipline because adopting lax fiscal policies must eventually lead to an exhaustion of reserves and an end to the peg. At the end, the eventual collapse of the fixed exchange rate would imply a big political cost for the policy maker, that is bad behavior today will lead to a punishment tomorrow. In fixed exchange rate regimes, change in exchange rate is possible by only government decisions. In other words, devaluation and revaluation are the main choices in determining the rates. Fixed exchange rate regimes do not only show low nominal variability by definition, but also low real variability, compared to floating regimes. However, there are less strict ways of fixed regimes such as pegs. Pegging is the most common system developing countries ever implemented to decrease volatility. Pegging can be used if,
· The degree of involvement with international capital markets is low,
· The share of trade with the county to which it is pegged is high
· The shocks it faces are similar to those facing the country to which it pegs,
· It is willing to give up monetary independence for its partner’s monetary credibility,
· Its economy and financial system already extensively rely on its partner’s currency,
· Its fiscal policy is flexible and sustainable
· Its labor markets are flexible
· It has high international reserves. Pinteris (2002),
Frenkel (1999) adds a few more requirements: “…a strong, well-supervised and regulated financial system. Otherwise, the country might simply convert currency-crisis vulnerability into banking-crisis vulnerability. Finally the existence of the rule of law is a necessary condition for a currency board, though not necessarily for dollarization. Proclaiming a currency board does not, as sometimes asserted, automatically guarantee the credibility of a fixed rate peg. Little credibility is gained from putting an exchange rate peg into the law, in a country where laws are not heeded or are changed at will. A currency board is not credibility in a bottle. It is unlikely to be successful unless accompanied by solid fundamentals.”
On the other hand, fixed oriented regimes may result in speculative attacks. These are the common elements of speculative attacks:
· Real exchange rate appreciation
· Deterioration in the current account
· Heavy external borrowing
· Distress of the financial system
· Poor growth
· Inflation stabilization programs and
· High real interest rates
Sachs et al. (1996) found that overvalued real exchange rates and recent lending booms, coupled with low reserves, relative to the short-term commitments of the central bank was a necessary condition for crisis.
The case for exchange rate flexibility is especially strong if the country in question is often buffeted by large real shocks from abroad. The logic here is once again due to Mundell although in this case it is the somewhat later Mundell (1963) of the model that linked his name to Fleming’s. If shocks to the goods markets are more prevalent than shocks to the money market, then a flexible exchange rate is preferable to a fixed rate. And, of course, foreign real variability is likely to be particularly large for exporters of primary products and/or countries highly indebted abroad – that is, a profile that fits many emerging market countries. Indeed, the 1990s produced large fluctuations in the terms of trade and international interest rates relevant for these countries. Note also that the preference for flexible exchange rates among countries with a heavy natural resource base extends into the OECD: Australia, Canada, New Zealand and some of the Scandinavian countries are good examples. In flexible exchange rate regimes, there is no government intervention in the foreign currency markets. Market agents determine exchange rates according to changes in supply and demand. There are negative and positive sides of flexible regimes as Wise and Roett (2000) mentioned “For flexible currencies, the benefits lie in the exchange system’s ability to adjust for shifts in competitiveness, to absorb real external shocks, and to mitigate both incoming and outgoing capital surges; … the temptation for governments to ease up on fiscal and monetary discipline in the absence of a nominal anchor”. The main advantage of fixed regimes is enhanced credibility by a grater macroeconomic discipline and reduction in inflation. On the other hand, it depends on trends in external sector, especially under conditions of high capital mobility and volatile financial flows. In fixed exchange rate regimes, nominal exchange rate can be used to achieve higher employment or improve balance of payments deficits.
So, one of the most important benefits of flexible exchange rate regime is that shocks can be absorbed easily without unemployment and inflation. Flexible exchange rate causes uncertainty in the currency market and exchange rate uncertainty causes market participants to reduce their activities in order to minimize their exposure to the effects of exchange rate volatility. “Most international transactions are realized after a time lag, and contracts are denominated in terms of the currency of either the exporting or importing country… If the volatility increases profit risk increases too”. Ozbay (1999) In other words, flexible exchange rate regime may cause to decrease in international transactions.
Recently, many economists are defending the middle solutions or sometimes they suggest that a country should change its exchange rate regime in response to economic conditions. For example, Frankel (1999) suggests interior solutions: “…Neither pure floating nor currency boards sweep away all the problems that come with modern globalized financial markets. Central to the economists’ creed is that life always involves tradeoffs. Countries have to trade off the advantages of more exchange rate stability against the advantages of more flexibility. Ideally, they would pick the degree of flexibility that optimizes with respect to this tradeoff. Optimization often, though not always, involves an interior solution.”
BACKGROUND OF EXCHANGE RATE REGIME APPLICATIONS IN TURKEY, IMPACTS ON FOREIGN TRADE
The export performance of Turkey during the last fifty years can be summarized in two episodes. First is 1950-1980 period and the second is after 1980. In the first episode, due to import substitution policy, the export was neglected and exports grew at lower rates. After 1980, foreign trade policy has changed considerably. In the second period, Turkey implemented export led policies. As a result of these policies, high growth rates of exports were achieved. However, policies in this period as a whole are directed to the same goal (liberalization) but are not homogeneous. After 1989, policies were more liberal (deregulation of capital movements).
Parallel to economic trends in the world, Turkey enforced the fixed exchange rate regime until 1980. This regime caused Turkish Lira to over valuate. As a result, Turkey had balance of payments crises a few times and had to devaluate its currency, because it had enormous foreign trade deficit during the period of 1970-80. The only policy Turkey had then was devaluation. In 1970, Turkish Lira was devaluated by 40%. In the following years, export growth was much greater than the average. So, in fixed exchange rate regime, policy-makers have power to affect the foreign trade.
number of legislative turkey were accepted by the parliament. movement of capital in the turkey is called the Decree number 32. with the decree number of 32 this turkey to be the exchange rate more flexible. turkey currency during the period of this movement into the capital deregulation. have a bad impact of this decision that the government lost control foreign exchange and interest rates. with this policy government eventually lower interest rates in order to attract foreign investors. this attracted only short term capital inflows. At the end, those inflows were to be used for financing the saving deficit of the economy.
In April 1994, Turkey had a severe financial crisis. There are two main views about the reason of 1994 crisis (Yeldan-1997): First view claims that the only reason of 1994 crisis was the public sector deficits. The other view argues that there had been some very important mistakes in timing and the order of the reforms. As a result, policy instruments (exchange rate, interest rate) became ineffective. That is why the growth in 1990s was a dependent of capital movements.
During the crisis, a great amount of capital outflow occurred and Central Bank reserve decreased. As a result, government decided to devalue Turkish currency and change the exchange rate regime.
After 1994, Turkish Lira was undervalued. As a result of this, export growth rate was high and import growth rate was less in this period.
IMF STABILIZATION PROGRAMS
Despite IMF claims that “The usual approach taken by the IMF on exchange rates has been to abide by a member country’s preferred exchange rate regime and tailor its overall policy advice accordingly… In the stabilization programs implemented after 1980, Exchange rate regime has been a major policy instrument. For example, as well as credibility, some flexibility of the regime was the important policy choice in the stabilization program implemented at the beginning of 2000.
Such programs typically use the exchange rate as a credible anchor for inflationary expectations, often leading to currency appreciations and relying on capital inflows attracted by arbitrage opportunities to finance growing external deficits.
AN APLICATION ON TURKEY’S EXPORT FUNCTION
This model is constructed to explain the export supply function of Turkey in particular the relation between real exchange rate and export. The model that is similar to that of Uygur (1997) can be seen below:
XL is the index of export of previous year. Countries or exporters tend to be able to increase the previous period’s export. So, countries give incentives to motivate exporters to export more than they did in previous periods. RIP is the real industrial production index. Turkey’s export consists of mainly industrial goods. So, industrial production is one of the important variables explaining exports. REX is the real exchange rate index (Foreign Exchange/Turkish Lira). This is the real value of TL. The higher the value of TL is the more expensive the export goods of Turkey are.
X: Index of Exports in US Dollar
RIP= (Industrial Production index/ Price index)
REX= (Nominal Exchange rate index*PUSA-index)/PTR-index
As a result, for developing countries, credibility is more important than elasticity. Turkey, as a developing country, should implement the Crawling Peg Regime. Because the credibility of economic policies in this regime is quite high and it also provides elasticity. But, unless Turkey controls the speculative capital flows, this regime won’t be successful. So, success lies upon sound economic policies, which result in agent’s confidence.