By Brian Hoyt
Editor's note: Sebastian Weber and Charles Wyplosz are from the Graduate Institute in Geneva. They are the authors of a World Bank working paper on Exchange Rates during the Crisis (.pdf).
A key leitmotiv as the financial crisis unfolded was to avoid a repeat of the policy mistakes of the Great Depression, including the beggar-thy-neighbour competitive devaluations which have had devastating effects causing rising protectionism and a collapse of international trade (Kindleberger, 1973).
Unlike in the '30s, only some 42% of countries are officially pegging their exchange rate today, implying that movements in the exchange rate do not necessarily reflect official decisions, but are rather market-driven. Furthermore, governments today have many more policy tools at hand, ranging from fiscal policy over labour markets to monetary policy measures, making them less reliant on measures that are perceived as beggar-thy-neighbour.
While exchange rates have moved a lot since the onset of the crisis, these movements have mostly been interpreted as a byproduct of expansionary policies and the move to ‘quality’. Sharp depreciations in countries like the UK or South Korea have not been welcomed by the authorities, at least not officially. Intentions, of course, are hard to detect and no one will argue that expansionary policies were not needed.
The sharp appreciation of the dollar against most currencies by the end of 2008 (see graph) and the following decline in the dollar’s value starting again in the beginning of 2009 had two immediate consequences:
First, countries which pegged to the greenback, be it a dejure or defacto peg, lost heavily in competitiveness with respect to most of their floating counterparts in late 2008. This heightened the incentive for many countries, already constrained in their policy options, to devalue against the dollar to “reestablish” their export competitiveness in a time that global demand was already collapsing. Countries like Singapore and Vietnam gave in and lowered their currency’s respective value to the US dollar. Similarly, Kazakhstan and Armenia devalued against the dollar in response to the decline in the value of the Russian ruble and the devaluations in Ukraine and Belarus.
Second, the ongoing fall in the value of the US dollar since the beginning of 2009 shifts the adjustment burden to a greater extent on those countries which did not depreciate (too much) against the dollar in the midst of the crisis. This includes the euro zone but also Eastern European nations which peg to the euro. Many of these countries already had large pre-crisis trade deficits which tended to widen even further. On the other end of the specter remain the nations with the big surpluses which often peg more or less loosely to the dollar, including several Asian countries, some of which strengthened their nominal competitiveness even more throughout the crisis. Hence, the fall in the dollar’s value may be conducive to the reduction of the US deficit position, and it is likely to contribute to an increasing imbalance between various European states and Asian economies that anchor to the dollar.
Hence, even as the worst of the current crisis may be over, there remains a big uncertainty regarding the future developments of exchange rates and to which extent they will be supportive in facilitating adjustments to external imbalances of countries.
While direct foreign exchange interventions remained contained during the crisis, the incentives to use the exchange rate channel as a mean to overcome the consequences of the crisis (high debt and low demand) remain very vivid.