Too late for Sri Lanka as IMF paper busts ‘flexible exchange rate’ myth on exports

ECONOMYNEXT – An International Monetary Fund staff discussion paper has said that countries with ‘flexible exchange rates’ (read depreciation), has limited gains on exports but market participants in those countries will be hit by debt problems.

Classical economists have long pointed out that countries with depreciating currencies remain poor because unsound money de-stabilizes the basic foundation of an economy.

Unsound Money

A countries with depreciating currencies have an monetary arrangement that is impossible to operate in practice involving money printing (policy rate) and exchange rate targeting (forex reserve collection) involving contradictory money and exchange policies, long promoted by the IMF.

Flexible exchange rates destroys all financial capital, destroys peoples living standards boost poverty, triggers demand for subsidies and political upheavals and leads to demand collapses domestically and also bad loans and sovereign default, classical analysts say.

The entire boom of East Asian countries in the 1980s and 1990s, including Singapore (modified currency board), Malaysia, Taiwan, Thailand and Hong Kong (currency board) was based on stable exchange rates after the collapse of the Bretton Woods soft-peg system.

It is not possible to maintain stable exchange rates for any length of time without complementary money and exchange policies.

East Asian laggards Philippines and Indonesia which still export labour to the Middle East and neighboring countries with sound money, have had severe repeated currency crises, or chronic depreciation, while the other nations have only had one East Asian crisis.

Korea had periodic devaluations, and repeated reforms of the central bank until the mid 1980s.

Vietnam’s exports started to grow and poverty to fall after the State Bank of Vietnam went through reforms in the late 1980s and early 1990 after the economy imploded shortly after the 1986 opening of the economy due to central bank re-finance.

Cambodia’s growth started after the economy was effectively dollarized and use of central bank money became virtually redundant. The lack of ability to use monetary policy has stabilized the currency at around 4000 riel to the dollar after falling from 50 in a decade.

Monetary stability that comes from a stable exchange rate encourages foreign investment, which in turn boosts exports, and raises living standards with fast rising real wages and domestic demand.

The lack of destruction of domestic capital, reduces the need for the government to borrow abroad while higher real wages halts the call for subsidies.

The two global export giants of the Bretton Woods era, Germany and Japan also had the stable fixed rates. Their currencies appreciated after the break-up. The yen has appreciated from 368 during the Bretton Woods to around 100 now. Singapore has appreciated from 3 to 1.2 to the US dollar.

Currency depreciation however destroys real wages (which may trigger political unrest or strikes) giving a subsidy to owners of such firms and may drive capital to exports, as domestic demand also collapses, at least until wages catch up.

The IMF working paper which however used a partly Mercantilist trade linked argument based on what the authors called ‘dominant currency’ (such as the US dollar) pricing of exports and borrowings to explain why currency depreciation does not help trade.

Limited Gains

Sri Lanka’s rupee has collapsed steadily from 113 to 185 to the US dollar but exports have hardly moved, while Cambodia which is dollarized has seen an export boom in the same period.

“Faced with an unprecedented shock of collapsing global demand and commodity prices, capital outflows, major supply chain disruptions and a generalized drop in global trade, many emerging markets and developing economies’ (EMDEs) currencies have weakened sharply,” IMFs Gustavo Adler, Gita Gopinath and Carolina Osorio Buitron said.

“Building on a new dataset, research laid out in a new IMF Staff Discussion Note indicates that the short-term gains from weaker currencies may be limited.

“This is especially true for EMDEs where firms price their international sales and finance themselves in a few foreign currencies, notably the US dollar—so-called Dominant Currency Pricing and Dominant Currency Financing.”

The authors said amid the Covid-19 crisis, depreciation would not help either.

“Our analysis on dominant currencies suggests that the weakening of EMDE’s currencies is unlikely to provide a material boost to their economies in the short term as the response of most exports will be muted, besides the physical disruptions to trade from supply and demand disruptions,” the authors said.

East Asian currencies with better central banks which initially saw their currencies weaken have rebounded as credit weakened.


Contrary to the experience of Germany, Japan, Hong Kong, Singapore, Taiwan and China after 1993, Mercantilists believe that currency depreciation helps exports.

Classical economists have pointed out that US Mercantilists in particular (now seen in Trumpism) falsely blamed ‘undervalued’ East Asian currencies for their own trade deficits, which was an outcome of capital inflows coming from US asset purchases by foreigners (US government bonds by foreign central banks and foreign direct investment).

The Western financial press tended to amplify the false doctrine, critics say blithely ignoring the evidence of East Asia and the collapsing currencies of Latin America.

“The central assumption underlying the traditional view on exchange rates is that firms set their prices in their home currencies,” the IMF paper said.

“As a result, domestically-produced goods and services become cheaper for trading partners when the domestic currency weakens, leading to more demand from them and, thus, more exports.

“Similarly, when a country’s currency depreciates, imports become more expensive in home currency terms, inducing consumers to import less in favor of domestically-produced goods.

“Thus, if prices are set in the exporter’s currency, a weaker currency can help the domestic economy recover from a negative shock.”

Denominator Currency

But most countries set their export prices in the US dollar, which the authors call ‘Dominant Currency Pricing’ or the ‘Dominant Currency Paradigm’.

In classical economic terms the phenomenon is a known as a denominator currency, made popular due to their relative soundness compared to their competitors, analysts say.

Throughout history such currencies have emerged, the Sterling Pound until World War I, when gold convertibility was suspended, allowing the US dollar to gradually take-over and even earlier in history such as Emperor Constantine’s solidus also known as the dollar of the Middle Ages) and the Maria Theresa thaler, (which was sometime independently minted).

Constantine’s currency changes are similar to modern day ‘central bank reforms.’

The IMF itself failed to popularize its own denominator currency, the special drawing rights.

Meanwhile the authors said most trade is now invoiced in dollars.

“In fact, the share of US dollar trade invoicing across countries far exceeds their share of trade with the US. This is especially true in EMDEs and, given their growing role in the global economy, increasingly relevant for the international monetary system,” the authors said.

“When export prices are set in US dollars or euros, a country’s depreciation does not make goods and services cheaper for foreign buyers, at least in the short term, creating little incentive to increase demand.

“Thus, in EMDEs, where dominant currency pricing is more common, the reaction of export quantities to the exchange rate is more muted and so is the short-term boost of a depreciation to the domestic economy.”

Liability Dollarization

The IMF paper also brought forward a more classical argument based on sound money for maintaining monetary stability.

Classical economists call the phenomenon liability dollarization.

“The prevalence of the US dollar is also a feature of corporate financing in EMDEs,” the authors said.
“This feature—Dominant Currency Financing—means that exchange rate fluctuations can also have effects through their impact on firms’ balance sheets, a phenomenon widely studied in the literature.

“A depreciation that increases the value of a firm’s liabilities relative to its revenues weakens its balance sheet and hinders access to new financing, as firms’ capacity to repay deteriorates.

“However, this effect depends on the currency in which revenues are earned, that is, whether revenues are in foreign currency or in local currency.

“Exporting firms that use the US dollar or euros for both pricing and financing, are “naturally hedged” as liabilities and revenues move in tandem when exchange rates fluctuate.

“This means foreign currency financing is less of a concern when concentrated in exporting firms.

“Revenues and liabilities of importing firms, however, are typically not matched, and exchange rate fluctuations bring about balance sheet effects that constrain financing and import volumes.

“Dominant currency financing tends to amplify the effect of a country’s depreciation on its imports.

“The prevalent use of the US dollar in corporate financing also means that a generalized strengthening of the US dollar can have globally contractionary effects through importing firms balance sheets.”

Analysts say more than private firms, governments, which have their revenues wholly denominated in domestic currency also faces the threat of default when the ‘flexible exchange rate’ collapses. (Colombo/July22/2020)