A WORLD OF DIFFICULT CURRENCY CHOICES

Asked to list major economic policy issues facing the United States, few U.S. citizens would likely mention the choice of exchange rate regime. After all, our continental economy is relatively closed to international trade. Exports plus imports account for less than 30 percent of U.S. GDP, compared with 65 to 80 percent for Mexico and Canada, and well over 100 percent for entrepôts like Hong Kong. Moreover, the prices of many imported commodities — like oil and aluminum — are denominated in dollars. Thus, wide swings in the value of the dollar in terms of other currencies have no effect on the dollar price of these important imported inputs to production.

But for many other countries, the choice of currency arrangement is a crucially important decision - one that is being made, and revised, in a great variety of ways. Should a country let its currency float freely, with its price in terms of another currency determined entirely by (erratic) supply and demand? Or should it try to fix the price of its currency against that of an important trading partner? Or is a compromise, a controlled degree of flexibility, possible? Moreover, if a country does decide to fix or manage, against what currency should it do so?

In the new world of increasingly open capital markets, many small and not so small countries have found that flexible exchange rates can turn volatile and destabilizing. This volatility discourages trade and investment - even between partners in a free-trade arrangement. Despite NAFTA, trade among the Canadian provinces and among the U.S. states greatly exceeds U.S.-Canadian cross-border trade largely because the shifting exchange rate acts as a barrier.

Big exchange rate swings can also spill over to domestic prices. Developing countries with a history of high inflation (like prestabilization Argentina and Brazil) have found that a weak currency can quickly reignite inflation expectations as import prices start to rise. But countries with low inflation have learned that they can attract too much interest from foreign investors. Feedback between soaring equity or property prices and a rising exchange rate can create fragile bubbles in these countries' financial markets. Moreover, small countries are not alone in struggling with unwanted aspects of flexible rates. Fearing that the strong yen could undermine Japan's budding recovery, the Japanese intervened in the forex markets many times last year in an effort to depress their "floating” exchange rate. Europeans, on the other hand, have voiced concern about the impact of the weak euro on inflation.

Given these drawbacks to flexibility, the urge to fix is strong. But economic history provides ample evidence that individual country efforts to fix the exchange rate are usually unsuccessful and often lead to disaster. The Asian crisis provides the most recent examples, as several currencies were torn from dollar pegs that had become unsustainable. Basically, when countries have different economic experiences, different rates of inflation or productivity growth, say, or when they have different exposures to economic shocks such as a drought or an oil price surge, maintaining a fixed exchange rate eliminates a possible adjustment mechanism. Unless the less competitive country endures a bout of falling prices or employment, investors are likely to force an abrupt and disruptively large exchange rate shift. National monetary authorities hold limited supplies of foreign currencies to use in stabilizing their own currency in the foreign exchange market, where transactions amount to well over $1 trillion a day. So individual monetary authorities are sitting ducks when private investors decide that a fixed exchange rate is not sustainable - at least so long as capital markets remain open.

Thus, some countries have decided to seek exchange rate stability by banding together in currency unions or blocs, as in the European Monetary Union, or by adopting another country's currency and monetary policy as its own. In the latter case, a few countries, notably Argentina and Hong Kong, have established a currency board, an arrangement in which the domestic currency is backed by U.S. dollars (or euros) and the money supply automatically expands and contracts with the flow of foreign exchange reserves. Other nations, like Panama and the members of the CFA Franc Zone, have given up their domestic currency and use the dollar or the euro instead. Ecuador has also announced its intent to dollarize but may find it hard to meet the prerequisites, like strong banks and disciplined fiscal policy, for such a system. Both arrangements require a country to forgo monetary policy independence and make do with limited lender-of-last-resort facilities. But these small, open countries say that, since they cannot really hope to have an independent monetary policy in any event, that loss is a small price to pay for obtaining relative price stability. And, with the elimination of currency risk along with the elimination of the domestic currency, they gain cheaper access to foreign capital.

HOW THE COUNTRIES LINE UP

As shown in the accompanying map, IMF member countries have distributed themselves rather evenly along the spectrum from free floats to the irrevocably fixed rates of a currency union. At the flexible end, 50 countries, including many economically or physically large nations like the United States, Japan, Australia, and India, allow their currency to float independently. However, several members of this group (Japan, Canada, and Brazil, for instance) intervene fairly frequently in an effort to offset "disorderly” or unwelcome market forces. Another group of 45 countries embraces some form of limited flexibility; 26 "manage” their float, while 19 allow the exchange rate to fluctuate within a specified band or to move gradually ("crawl”) along a specified path. A further 44 are trying to maintain a traditional exchange rate peg. Finally, 45 countries have sought additional stability by joining a currency union or by taking a major world currency as their own.

Of course, the map provides a snapshot at a single point in time. Earlier snapshots would show that the currency turmoil of the last decade has pushed several countries, like Korea, Thailand, Brazil, and Colombia, from conventional or crawling pegs to untethered floats. Indeed, since 1990 the number of floating currencies has almost doubled, while the number of conventional pegs has fallen by half. In addition, with the launch of the euro in early 1999, the group of countries belonging to currency blocs has jumped significantly, while the group expressing at least modest interest in currency unions has grown even more. Indeed, some well-positioned observers, including Rudi Dornbusch of MIT and Ron McKinnon of Stanford, advocate the creation of two or three large currency blocs. Harvard's Richard Cooper imagines the development of a single world currency in the first quarter of the twenty-first century.

POLITICAL CONSEQUENCES?

From this perspective, the map also shows the evolution of the euro- and dollar-based currency blocs to date. The 44 countries with links to the dollar (including the U.S.) account for 38 percent of world output, while the 38 countries with euro links represent about one-fourth of world product. Although the euro has weakened against the dollar since its launch in early 1999, the euro is likely to grow in importance as a global currency as the European Monetary Union expands to the east, and as euro financial markets develop. Already, for a variety of reasons, including novelty, 46 percent of international debt securities issued in the first three quarters of 1999 were denominated in euros (versus 45 percent in U.S. dollars). The euro share was a good deal larger than the combined shares of the several European currencies in recent years.

But the map also raises questions about the currency bloc idea. In particular, the map shows little evidence of an emerging Asian cluster. Many Asian nations trade almost equally with Japan, Europe, and the United States. So which currency would be an appropriate nucleus for an Asian currency bloc? Given time and Asia's history, might the Chinese yuan be a reasonable candidate? And how are political relations among the members of a given currency union and between members of major currency blocs likely to evolve? Will the map of global currency arrangements begin to merge with the map of geopolitical arrangements? If so, the choice of currency regime involves yet another dimension, a dimension that should prompt U.S. citizens to pay some heed to other countries' currency choices.

Acquiring the Map

If you would like us to mail you a copy of the magazine with the map showing the different exchange rate systems around the world, please send us an e-mail with your postal address and note that you would like the exchange rates map.