Dr. Wayne Henry
THE PROPOSAL by the Leader of the Opposition, Edward Seaga, for the re-introduction of a fixed exchange rate in Jamaica and subsequent discussions on the choice of exchange rate regime for the country are not trivial issues. An examination of the performance of the Jamaican economy over the last decade reveals the difficulty experienced in trying to attain low interest rates while maintaining low inflation and relative stability in the foreign exchange market. This article seeks to elucidate some of the issues surrounding exchange rate regimes and the Jamaican economy.
An exchange rate is the price of one currency in terms of another. It is the ratio at which currencies trade for each other. Thus, for any two currencies there exists an exchange rate. For example, if it takes $61 Jamaican dollars to purchase one United States dollar, the exchange rate is J$61 to US$1, or one Jamaican dollar can purchase 1.6 U.S. cents.
There are generally three types of systems or regimes governing an economy's exchange rate. It can have a fixed exchange rate, where the value of the country's currency is fixed or pegged at a certain level for a long period of time. To maintain the currency at this level, the central bank of the economy will buy or sell foreign currency where necessary to meet changes in demand or supply.
Second, there is a flexible or floating exchange rate system (clean or pure float), where there is no intervention by authorities, but the market forces of demand and supply determine the value of the currency.
Finally, an economy can have a managed floating exchange rate system (a dirty float) where the authorities allow the exchange rate to respond to market forces, but intervene as necessary to prevent large changes in the value of the currency, which may be perceived to be destabilising to the economy. Under a fixed rate system if the authorities change the value of a currency from one level to a lower level, the currency is said to have experienced a devaluation (e.g. from J$61 to US$1 moving to J$70 to US$1). Under the flexible rate system, if the currency falls in value it is said to have experienced a depreciation.
Jamaica had a fixed exchange rate regime until September 1990, when the foreign exchange market was then liberalised to facilitate a flexible exchange rate system, or more properly, a managed float regime.
Among other things, the Bank of Jamaica (BoJ) has, as its mandate, the safeguarding of the value of the Jamaican currency. It has often intervened in the foreign exchange market to help meet demand for U.S. dollars by selling from its net international reserves (NIR). Where this intervention has not been sufficient, the BoJ has relied on interest rate policy, whereby relatively higher interest rates in Jamaica increases demand for the Jamaican currency, as local investment instruments now yield a higher return. The high interest rate environment, which has characterised the Jamaican economy over the past 10 years, has been largely sustained by the Government's need to borrow to finance the excess of its expenditure over its revenues (the fiscal deficit).
This has hurt the local manufacturing sector due to the high cost of capital, as well as diverted funds that could otherwise be used for investment in productive facilities (buildings, machinery, expansion of capacity) which would more readily lead to job creation and growth than investment in financial instruments.
Some would argue that the managed float regime has not worked well in Jamaica: that the high interest rate environment has stifled growth and that the operations of the central bank could be more independent of political influence. But what of the alternative of a fixed rate regime?
The essential attractiveness of a fixed rate regime is the stability that it affords. For example, if the exchange rate is pegged (fixed) to the US dollar, there would no longer be daily fluctuations of the currency in response to demand and supply conditions. The central bank would use its store of reserves to maintain the value of the local currency. With the fixed rate, interest rates would fall to be in line with interest rates prevailing in the U.S. economy when adjusted at the exchange rate. If there was not this parity (equality) the economy with the higher interest rates would see funds coming into it, which would increase its money supply and drive down interest rates to the parity level. Similarly the economy with the relatively lower interest rates would see an outflow of funds, driving up interest rates to parity. The interest rate reduction afforded by the fixed rate would lower the cost of capital to the manufacturing sector et al. The relative stability in the exchange rate should also encourage investment and allow for better long-term, strategic planning.
BIGGEST DRAWBACK
The biggest drawback with the fixed rate system, however, is in its inability to deal with negative economic impacts to the economy. Because an exchange rate is a price, when market conditions adjust, prices should change to reflect the same. With a fixed rate there can be no fluctuation in the currency value to deal with these shocks. Such shocks would have a direct impact on the economy without the insulation of currency fluctuation. If the fixed exchange rate is relaxed at such a time, it may be more destabilising to the economy. The Argentinean example highlights this point. The stability offered through the introduction of the fixed exchange rate system in Argentina benefited the economy positively in the near 10-year period. But when the debt burden peaked and the confidence crisis emerged, suggestions to float the Argentinean peso were rejected. Many countries that had fixed exchange rates prior to the 1970s abandoned them after the oil price crisis in 1973.
Another problem with the fixed exchange rate arises if the central bank has insufficient reserves to maintain the peg. This, along with the fact that if the fixed currency is perceived to be over-valued, would give rise to an informal market (black market) in foreign currency. Finally, a fixed currency regime emphasises fiscal policy over monetary policy. Governments can affect economies through changes in public sector spending and taxation (tools of fiscal policy) or through the central bank's affecting the interest rate through changing money supply (monetary policy). Because of the need for interest rate parity under a fixed rate system, monetary policy is virtually ineffective, leaving the Government to rely on fiscal policy to affect the economy. If there are prior conditions that limit the flexibility of the Government in this regard (e.g. tax policy in need of review, fiscal constraints particularly due to debt, or a significant informal sector) then the policy overall will be ineffective.
The debate concerning the appropriate exchange rate regime for an economy is a continuing one. There is no hard-and-fast rule, or a one-size-fits-all solution. Each country should adopt an exchange rate regime that is best suited for it given the characteristics and conditions within that country. Regardless of the choice of exchange rate regime adopted, if the fundamentals of an economy (economic growth, unemployment, productivity, debt levels) are weak, the economy will suffer. For Jamaica, our focus must be on improving the efficiency of the economy: eliminating the fiscal deficit, reducing the national debt, increasing productivity in certain sectors, creating jobs and growing the economy.
Dr. Wayne Henry is a lecturer in the Department of Economics at UWI, Mona Campus. Email: wayne.henry@uwimona.edu.jm
