Significance of exchange rates for the economy

The exchange rate between the Malawi kwacha and other currencies, notably the United States dollar and the British pound have been taking place from time to time since the kwacha was launched in the early 1970s.

But these changes never aroused so much public interest if not hostility as they did during 2011 and 2012. Why not?

These were economically very difficult years. Foreign reserves at the central bank had fallen close to a vanishing point. Shortage of reserves resulted in the scarcity of such essential commodities as petrol and diesel.

Our development partners were attributing our economic slowdown to the fact that our currency was overvalued, thereby making our exports uncompetitive. Our late president Bingu wa Mutharika was, at first, adamantly opposed to devaluation for fear that it would ignite imported inflation and that this would hurt the rural masses. Chiefs and political party activists were supporting the president in his resistance to the pressure for devaluation.

However, reluctantly, he devalued the kwacha by 10 percent. As expected, there was a general rise of prices. The International Monetary Fund (IMF) pressed for a bigger devaluation, otherwise, it was not going to release its funds to the Malawi Government treasury.

Mutharika began to relent his opposition when the World Bank talked about rendering assistance to cushion the effects of devaluation on the very poor.

With the advent of the Peoples’ Party (PP) government led by President Joyce Banda, the proverbial new broom swept clean. The moment they devalued the currency by about 49 percent, they announced that the kwacha would; henceforth, be a flexible or a free floating currency. What does this mean and what advantages and disadvantages does it have for us?

A bit of history about exchange rate is appropriate here. Originally, the common currency in international trade was gold. Countries fixed exchange rates in terms of gold. During the period between World War I and II, a number of countries found adhering to the gold standard inimical to their macroeconomics, namely; employment, price level and economic growth.

Throughout what was known as beggar thy neighbour policies, each country tried to save itself by refusing to cooperate with its trading partners.

As the end of the World War II was in sight, most countries in the free market system met in the city of Brettonwoods, New Hampshire in the United States of America (USA) and set up two institutions for encouraging financial and economic cooperation in the world. These were the IMF and the World Bank. Our interest here is on the IMF.

Through the IMF, member countries announced exchange rates for their currencies vis-a-vis gold and the US dollar. From that time, the US dollar became the yardstick by which each currency was measured. The IMF kept surveillance over the movement of the currencies. The dollar value in terms of the gold remained fixed until 1971 when President Nixon denounced devaluation of the dollar in terms of gold. Why?

Here is the crux of the matter. The US dollar had been adopted as the main reserve currency because the American economy was by far the strongest in the world. By the early 1970s and especially after the Arab-Israel war and the decision of the Organisation of Petroleum Exporting Countries (Opec) fuel prices rose astronomically, the US economy was experiencing new levels of difficulties. The policy makers there decided that only dollar devaluation would make Americas export more competitive and new health would be injected into the American economy.

This should remind us that countries stick to a certain exchange rate or system so long as it either stabilises the economy or makes it grow at desired rates. If these conditions are not met, a country will change from one system to another. In a nutshell, we can say the systems are fixed, flexible (floating) or a mixture of the two. Degree to which a system is fixed or free floating differs from country to country.

Professor D. Daniels et al in their massive book ‘International Business’ list about eight types of exchange systems which we must look at in order that we appreciate to which category our own system belongs now and what it will belong to in future.

 

Continues on Friday