By Frances Coppola
Maintaining a stable exchange rate encourages import-export trade, since it limits FX risk for businesses. Inflation in import prices can be reduced by maintaining a high foreign exchange rate, while lowering the foreign exchange rate can help exporters. Conversely, volatile foreign exchange rates can cause severe problems for import-export businesses. Sudden swings in currency values directly impact the bottom line and can be difficult to hedge against. Controlling currency exchange rates to encourage trade can therefore be both electorally popular and economically advantageous.
History shows, however, that when global economic conditions are difficult, clinging to a fixed exchange rate system can be disastrous. In his book “Golden Fetters,” the economist Barry Eichengreen explains how the post-World War I gold standard caused deep depression in those countries, such as the U.S., that remained on it longest. Countries such as the U.K., which abandoned the gold standard and allowed their currencies to float against other currencies, fared much better.1,2
Some argue that the current deep depression in Greece is partly due to its adoption of the euro in 2001, replacing the traditional drachma. Greece now doesn’t have its own currency, so it cannot devalue that currency to make its exports more competitive. Consequently, exporting businesses are forced to reduce input costs, mostly by sharply cutting wages and laying off staff. The argument for a restored drachma is that the drachma’s foreign exchange rate would likely fall to a level that enables Greek businesses to compete effectively with those in stronger European countries3. But others warn that leaving the European single currency would be fraught with difficulty for a highly indebted country whose GDP has already fallen by a quarter, raising the prospect of economic and political collapse.4
When the natural tendency of the currency is to fall, there are two ways of maintaining its value: either the central bank buys back the currency, or the government imposes strict capital and exchange controls, effectively suspending the convertibility of the currency. Capital and exchange controls are a significant barrier to trade, since they prevent foreign businesses from repatriating earnings. For example, foreign businesses currently have large amounts of money in Venezuela, which they cannot repatriate because they cannot convert them to U.S. dollars.5 Foreign businesses are unlikely to want to trade with a country if they cannot repatriate earnings; similarly, investors are unlikely to want to invest.
Most central banks manage fixed foreign exchange rates by buying back their own currency. But this can burn through a country’s foreign currency reserves. When a country no longer has sufficient foreign currency to pay for essential imports, and cannot borrow more, there usually is a sharp fall in imports resulting in widespread shortages, business failures and economic recession. There may also be debt default by both the government and businesses if they cannot obtain the foreign currency needed to service debts.
For countries with low foreign currency reserves, a better option may be to adopt floating foreign exchange rates. A sudden switch to floating rates can be disruptive in the short term – but, as the example of Kazakhstan shows, it can work well in the longer term.
The central Asian state of Kazakhstan is an oil exporter. When oil’s price is high, its exchange rate also tends to be high, making its other exports uncompetitive (this is known as “Dutch disease”). So like many oil exporters, Kazakhstan pegged its exchange rate to the U.S. dollar. The Kazakh central bank maintained an exchange rate of about 185 tenge to the dollar, within a band of +3/-15.
This worked well while the price of oil was high. A central bank can freely create its own currency, so selling the tenge and buying dollars to maintain the peg was no problem. But the sharp oil price decline starting in the last quarter of 2014 put downwards pressure on the exchange rate: to maintain the tenge within its band, the Kazakh central bank sold U.S. dollars to buy its own currency, progressively draining Kazakhstan’s dollar reserves. Further, Kazakhstan’s giant neighbor Russia – a fellow oil exporter and principal trading partner – floated the ruble in the fall of 2014, pressuring Kazakhstan to follow suit. On July 15, 2015, the central bank widened the trading band to +13/-15 around 185 to the dollar. But to no avail: the currency exchange rate remained under pressure.6 On August 20, 2015, the Kazakh central bank floated the tenge.7
The tenge’s dollar exchange rate promptly fell sharply, reducing businesses’ earnings expressed in dollars.8 Import prices rose, fueling domestic inflation; the Kazakh central bank dampened this by raising interest rates, which reached 17 percent in February 2016.9 Analysts expressed concerns about the health of the Kazakh banking sector, while politicians severely criticized the central bank’s Governor. Three months later, the Governor was replaced.10
But in fact, Kazakhstan’s move to floating rates proved beneficial in the long run. The central bank stopped routinely selling dollars in November 2016, protecting the country’s precious FX reserves.11 Despite this, early in 2016 the tenge stabilized at around 336 to the dollar. It has remained there ever since.12 In parallel with this, the Kazakh central bank has progressively reduced interest rates since May 2016.
The stabilization of the exchange rate, albeit at a much lower level, has encouraged import-export trade, enabling Kazakhstan to emerge quickly from a shallow recession. In October 2016, the ratings agency Fitch described the outlook for Kazakhstan as “stable.” 13
Although the transition to floating exchange rates can mean a period of uncertainty and disruption, there can be benefits for businesses from allowing a currency to find its own level. The risk of FX crisis is eliminated and businesses can have confidence that foreign earnings can be repatriated. However, it can also be helpful for central banks to intervene in FX markets to dampen currency volatility, since wide swings in foreign exchange rates can be difficult for businesses to manage. The challenge for a central bank is to decide when to intervene, and when to leave well-enough alone.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Golden Fetters: the Gold Standard and the Great Depression 1919-1939,” The National Bureau of Economic Research (NBER);https://global.oup.com/academic/product/golden-fetters-9780195101133?cc=us&lang=en&.
2. “Nine charts showing why Greece has to leave the Euro,” Telegraph;http://www.telegraph.co.uk/finance/economics/11283931/Nine-charts-showing-why-Greece-has-to-leave-the-euro.html.
3. Greece Is Stuck With The Euro, And Vice Versa,” Bloomberg View;https://www.bloomberg.com/view/articles/2015-04-29/exit-from-euro-is-wrong-choice-for-greece
4.“Big Companies Can’t Get Their Dollars Out Of Banco De Venezuela,” Caracas Chronicles;http://www.caracaschronicles.com/2016/09/09/big-companies-cant-get-dollars-banco-de-venezuela/3
5. On realignment of Tenge exchange rate bank in relation to the US dollar, National Bank of Kazakhstan;http://www.nationalbank.kz/cont/publish787007_28968.pdf
6. Transition towards inflation targeting, National Bank of Kazakhstan;http://www.nationalbank.kz/cont/publish420901_29263.pdf
7. “Currency devaluation places Kazakhstan central bank under pressure,” Financial Times;https://www.ft.com/content/48495ba8-579f-11e5-a28b-50226830d644 8. “The National Bank of Kazakhstan sets the base rate and restores standing facilities,” National Bank of Kazakhstan;http://www.nationalbank.kz/cont/publish406615_31277.pdf
9. “Kazakhstan replaces central bank governor,” Financial Times;https://www.ft.com/content/ddc67386-814e-11e5-8095-ed1a37d1e096
10. “National Bank reduces its participation in the domestic foreign exchange market to preserve its reserves,” National Bank of Kazakhstan;http://www.nationalbank.kz/cont/publish699241_30156.pdf
11. “USD/KZT,” Bloomberg;https://www.bloomberg.com/quote/USDKZT:CUR
12. “Fitch Affirms Kazakhstan At ‘BBB’: Outlook Stable,” Fitch; https://www.fitchratings.com/site/pr/1013986 “Golden Fetters: the Gold Standard and the Great Depression 1919-1939,” The National Bureau of Economic Research (NBER);https://global.oup.com/academic/product/golden-fetters-9780195101133?cc=us&lang=en&