More on pegs and floats

In Malta any serious attempt to discuss certain economic and financial fundamentals is often undermined by crass political manoeuvring. Writing in this newspaper on November 11, Edward Scicluna questioned the current peg of the lira and talked about the deleterious effect this is having on the real economy. Opposition Leader Alfred Sant then took this up and said that the lira's "over-valuation" should be gradually corrected.

Premier Lawrence Gonzi eschewed any serious engagement on the issue, instead using it for political mileage by accusing Dr Sant of making a proposal which would ruin the working and middle classes and pensioners on the one hand and make the rich even richer overnight.

In Parliament, Dr Gonzi complained the government has been robbed of the benefit of rare expertise. It shows. He consulted his "experts" (as anonymous as Dr Sant's experts whom the Prime Minister lambasted) on the impact of any currency depreciation. Their analysis was astoundingly amateurish, limiting itself, it seems, to an alleged "dramatic and frightening" 10 per cent loss in income attributable to the lira's depreciation.

Any first-year student of economics will tell you that changes in currencies lead to changes in the relative prices of goods and services, particularly because of their varying impact on traded and non-traded goods, and in consumption patterns. The Premier's wizards urgently need to brush up their economics. They also ignored completely any positive effects a currency depreciation would in time have on exports, international competitiveness and jobs and thus on incomes.

The IMF's official de facto exchange rate regime classification (2003) shows a majority of the Fund's member countries still maintaining pegged exchange rate regimes. However, a growing number of countries have adopted more flexible regimes over the past decade.

The trend towards exchange rate flexibility is likely to continue for a variety of reasons. Rigid exchange rate regimes appear to be more crisis-prone than flexible regimes. Some countries that do not implement sound macroeconomic policies are often forced to adopt more flexible regimes. Others accept increased exchange rate flexibility in an effort to minimise the risks associated with economic and financial integration with the rest of the world.

For example, expanding trade linkages usually require greater exchange rate flexibility in response to external demand and terms of trade shocks. Evidence also suggests that countries that have liberalised capital flows either adopt more flexible exchange rate regimes or generally are more susceptible to being forced off pegs (Eichengreen and others, 1999).

Moreover, as economies mature, the advantages of exchange rate flexibility appear to increase (Rogoff and others, 2003). Countries which are not exposed that much to short-term capital flows may gain credibility and discipline fiscal and monetary policies by pegging their exchange rates. However, market economies with open capital accounts appear to gain from exchange rate flexibility.

The currency crashes of the 1990s underscore the evidence that the combination of pegged exchange rates and open capital accounts are prone to costly accidents. Thus, soft pegs and narrow bands (typically some two per cent) created a one-way bet for speculators under the EU's ERM I in the early 1990s.

Currently, there is talk that the newly-acceded countries may be confronted with the problem of the impossible trinity. Impossible trinity because a country must give up one of three goals: exchange rate stability, monetary independence (useful to cope with slumps) or financial-market integration. Countries can attain only two of the three goals simultaneously:

¤ lack of financial integration allows exchange rate stability and monetary independence;

¤ hard pegs (like the EU's single currency union) allow integration and exchange rate stability;

¤ a full float allows integration and monetary independence.

Flexible exchange rate systems have tended to favour those macro variables that have been identified in the theoretical and empirical literature as important channels for sustained economic performance (Bank of Canada, 2001): investment, trade openness, capital flows and fiscal or institutional rigidities. They highlight four criteria that guide the choice of the appropriate currency regime in market economies:

¤ Does it encourage flows that carry positive growth externalities or does it encourage flows that raise a country's vulnerability to financial crisis?

¤ Does it encourage investment and savings rather than consumption? Does it foster productivity growth by keeping output volatility in check?

¤ Does it favour the integration of the tradeables sector into world trade, namely by providing sustainable and competitive exchange-rate levels and by avoiding misalignments from the fundamental equilibrium rate?

¤ Does it cope with a country's given rigidities, namely in the fiscal area?

Those who support exchange rate flexibility (e.g. Larrain and Velasco, 2001) point to nominal wage and price rigidities, to the prevalence of real shocks in evolving markets and to the moral hazards implicit in pegs to make the case for exchange rate flexibility.

The situation in transition countries is varied (Granville, 2001). Some - the Czech Republic, Poland, and Slovakia - have moved to managed floats while Hungary has already committed to an ERM II-type exchange-rate mechanism (a +/- 15 per cent band around a fixed parity to the euro). However, a peg to the euro may be premature and subject to Walters' Critique - the boom-bust risk of shadowing an anchor currency when local inflation remains somewhat higher than in the anchor country.

Much has been made of the Balassa-Samuelson effect to justify real currency and wage appreciation in certain countries (Halpern and Wyplosz, 1995). The well-known analysis provides an appealing explanation of the long-run behaviour of the real exchange rate in terms of the productivity performance of traded relative to non-traded goods. Basically, the argument is that, as the productivity of traded goods rises relative to that of non-traded goods, there will be a tendency for the real exchange rate to appreciate.

The question, therefore, is whether productivity gains relative to a country's major trading partners will be sufficient to compensate for real currency and wage appreciation. EU accession involves the abolition of remaining barriers to trade, except in a few areas subject to temporary derogations. This means that many firms start facing higher competitive pressures from imported EU goods, that smaller firms suffer from the new burden of legal regulations required by the EU and that certain companies lose access to certain tax incentives which are not compatible with EU regulations. Sounds familiar? Such deprotection of sectors not previously exposed to international competition requires a real depreciation of the currency for internal and external balance.

Such considerations point to the potential risk that the eurozone hopefuls, Malta included, will enter the currency union at an overvalued exchange rate, as arguably did post-unification Germany. With a low inflation target set by the ECB, real overvaluation will only be corrected over time through even lower inflation, if not deflation. This is a painful process in the presence of price and wage rigidities; the French used to call it "competitive disinflation", suffering for an extended period until competitiveness had been restored (Blanchard and Muet, 1993).

Rather than alarming and misleading statements concerning the impact of any exchange rate adjustments, the Prime Minister should instruct the Central Bank to analyse the determinants of Malta's real exchange rate, with emphasis on long-term aspects, and search for the equilibrium path. This analysis should answer the question whether the appreciation of the lira reflects changes in fundamentals, such as productivity, the terms of trade, gross savings, world interest rates and foreign direct investment.