Fri | Sep 22, 2017

E.A. Shaw | Fixing the exchange rate

Published:Monday | February 20, 2017 | 2:00 AM

The proposal by Bank of Jamaica to introduce a foreign exchange auction in 2017 provides an opportunity to discuss a more fundamental issue of foreign exchange rate policy. This relates to whether Jamaica should have a fixed exchange rate or continue with the flexible exchange-rate system which now exists.

A fixed exchange rate seems to be the only logical foreign exchange rate system for a small, open economy such as Jamaica. Yet, several attempts have been made in the past to establish such a regime, without much success. It is now necessary to re-examine this matter.

Ruling out a currency board, a fixed exchange rate regime can be established by pegging the Jamaican currency to the US dollar at a fixed rate of exchange. Such a peg should form the basis of reducing the rate of inflation in Jamaica to about the average inflation rate of its main trading partners, which is about three per cent.

Such a low inflation rate would mean low real rates of interest, a low spread between borrowing and lending rates, and, therefore, low overall economic costs, as well as a low level of bad debts. Commercial banks should then be in a position to offer a positive real rate of interest on even small amounts of saving deposits, instead of the negative real rates that now exist. In general, a pegged exchange rate should give a boost to economic activity and help to create a sound foundation for growth and development of the country.

The main danger to a fixed exchange rate regime is the problem of currency overvaluation. This could occur if Jamaica's inflation rate remained higher than the average inflation rate of its main trading partners, because of increases of the real exchange rate.

The real exchange rate is the ratio of domestic prices of goods and services to foreign prices, so an increase of the real exchange rate means that domestic prices are increasing faster than foreign prices. If this is happening and the nominal exchange rate is fixed, the currency would become overvalued and, therefore, lose its external competitiveness.

 

INFLATIONARY CONDITIONS

 

The source of real exchange rate appreciation is to be found in the inflation of non-tradable goods and services. The inflation of internationally tradable goods and services, which should account for the bulk of price changes in the economy, would be controlled because of the fixed exchange rate. But in regard to the non-tradables, there are factors such as capital inflows that could create inflationary conditions in the economy, resulting in increases of the real exchange rate. Jamaica's situation points, however, to fiscal conditions and not capital inflows as the probable cause of such increases.

If the fiscal accounts are balanced, this would have the effect of stabilising domestic demand, and only minor monetary policy intervention would be required to keep inflation to the targeted rate. But it would be impossible to do so if there are large budget deficits. Such deficits increase liquidity in the monetary system, raise the demand for goods and services, and push up their prices, thus causing an increase of the real exchange rate.

Without the stabilising effect of a balanced budget, devaluation of the currency to restore its external competitiveness would become unavoidable. Such action, however, would also bring to an end the fixed exchange rate regime.

This has been the history of the failed attempts to maintain a fixed exchange rate in the past. Policymakers seem to have been unaware of the link between the fiscal balance and exchange rate stability. The available evidence supports this conclusion, since Jamaica has been able to achieve a budget balance in only a few of the past 50 years. The conclusion to be drawn is that fiscal discipline is a necessary and essential condition for maintaining a fixed exchange rate regime.

Apart from the exchange rate, the current estimate of consumer price inflation seems to be limited to working-class households. A more comprehensive measurement of consumer price inflation is required to provide more accurate cost comparisons with our main trading partners. The base year of any new index that is constructed will also need to be updated regularly (say, every five years) to ensure that it reflects current, and not outdated, household expenditure patterns.

The proposed foreign exchange auction is expected to reduce the current volatility of the nominal exchange rate. This could therefore be an important interim measure until the necessary supporting conditions are in place for the introduction of a fixed exchange rate regime. This should be the ultimate goal of foreign exchange rate policy.

- E.A. Shaw is an economist. Email feedback to columns@gleanerjm.com.