Saturday, December 17, 2005
Exchange rates fluctuations
Following Asian economic crisis, the Interim Committee of the Board of Governors of the IMF, stated that “ members should be able to choose a regime that is appropriate to their particular circumstances and longer term strategy. The choice of exchange rate regime, and the implementation of supporting policies, are critical for countries` economics development and financial stability, and in some cases potentially for the world economy”. The choice of an appropriate exchange rate regime should therefore be approached pragmatically.
Free floating exchange rates means advantages but also some risk. Nominal exchange rates fluctuations keep external shocks out of the real variables , such as business activity and employment. On the other hand it may cause excessive volatility and free ride risks. But free exchange rates fluctuations, also have distributional effects. A depreciation on domestic currency favour export producers but punish consumers. An appreciation favour consumers , but may harm export producers, depending on theirs management decisions .Therefore, considering risks, and distributional effects of exchange rates fluctuations ; Central Banks have “fear of floating”
The previous experience for Chilean economy was based on, Capital account regulations , while the exchange rate was quasi-pegged within a band that targeted the real exchange rate (RER).This instrument was of limited effectiveness, when the Asian crisis generated a negative external shock on exports ,and afterward on capital flows.
On September of the year 2000,the Central Bank decided to have a free floating exchange rate market, while keeping the chance to intervene under extraordinary circumstances. Since then, exchange rate in Chile have fluctuated with no clear long term trend, so volatility has increased, although it looks like it is part of the adjustment to a lower long term real exchange rate level . In fact, average real exchange rate in the period 1990-2005, is lower than the one of the period 1986-2005. On the basis of a long term perspective, this is a key factor, once it comes to the argument of whether Central Bank should intervene or not, to rescue the exchange rate deviation from its long term equilibrium value.
However there is an additional point. Chilean economy needs strong firms to compete on the global markets . Its level of openness, requires some known macroeconomics conditions, but also appropriate management models on the firms side, specially the type of model equivalent to the first best approach, which keep cost under control and productivity always increasing. The second best is to seek product differentiation, emphasizing quality and technical assistant .In other words ,this means, firms capable of facing different challenges. But conventional macroeconomics ,assumes no role for firms decisions process when exchange rates are moving in any direction. For instance, an increase the international price of exporting goods due to appreciation of domestic currency (looks the graph),call for the Central bank to intervenes to avoid the negative impact on exports. But, whether export fall or not it will depend on :
• The price elasticity of demand of such products. Low price elasticity of demand means a softer impact on export volume. High price elasticity of demand , means a greater impact on export volume. The former case, is typical of sophisticated product with high quality standards. The latter, is typical of agricultural products .-
• The firms decisions to reduce the impact of international prices fluctuations, on its export revenues. The firm may decide to work on either reducing costs, or prices to match the increases due to appreciation, lowering the profits. On a medium term scenario it is also possible to focus on new markets, and innovations to increase quality. Firms are no neutral when it foucs on international markets.
A competitive firm must be able to face different situations affecting either its price or cost structures ,without other support than its own efficiency level. What it would be the case whether shipment cost increases?. What it would be the case whether insurance cost increases? .Who would protect firms in such a case? .-
Central Banks loose some of its autonomy when intervenes to help some specific interest group and to harm others (consumers). This does not means that Central Banks, should evaluate carefully the every situation, but always taking into account firms capabilities to make theirs own decisions.