The failure of currency floats

This belief was based on the conventional wisdom that floating rates were sensitive to current account balances. This view may have had merit in an age when capital flows into developing countries consisted mostly of debt and foreign aid that basically financed the current account deficit. However, even as early as the mid-1990s, capital flows to developing countries were far in excess of what was required to finance current account deficits. During 1994-96, the cumulative current account deficit of developing countries averaged $86.05 billion, while the net addition to their foreign currency reserves?the net excess of capital inflows over what was required to finance the current account deficit?was $99.16 billion.

The dwarfing of the current account by the surge in the capital account continues unabated. In 2003-05, the cumulative current account surplus of developing countries averaged $356.13 billion. In a trade led global economy, this would have been balanced by equivalent outflows from the capital account in the overall balance of payments. However, there was a net addition of $453.19 billion to the reserves of developing countries that year.

Exchange rates are determined by the demand and supply of different currencies at any point of time, just like any other commodity. It is the combination of trade and capital flows?including the demand for arbitraging real interest rate differentials?that determines exchange rates. The strategy of ?sterilised intervention? currently followed by several developing countries is an acknowledgement of the new reality that market determined exchange rates can no longer be expected to nudge the current account balance back to equilibrium.

It is pertinent to note that the rupee has been appreciating faster than the currency of several other developing countries despite India?s substantial current account deficit. Between October 2006 and October 2007, the rupee appreciated twice as much against the US dollar as the Chinese Yuan, despite the fact that China is running a current account surplus of about 9-10% of GDP, compared to India?s deficit of 2-3%.

The current account equilibrium should not, of course, be read as zero. Indeed, it has been long believed that developing countries should run current account deficits to augment domestic savings in raising investment and growth. As with a fiscal deficit, though, the desirable level?the figures usually cited are 2-3% of GDP?is arguable. If developing countries are able to leverage (which they are currently able to) and absorb (which unfortunately they are not, since their huge reserves end up financing US consumption) much larger levels of foreign savings, much higher current account deficits can be sustained. The US has been able to sustain current account deficits of 4.5-6.5% over the last five years without an adverse macroeconomic fallout in the form of high inflation and interest rates, or low growth.

Back when capital flows to developing countries were modest, market-determined exchange rates could be used as an effective policy instrument to stabilise external imbalances. However, with capital flows dwarfing trade flows, there is now no effective marker for what an appropriate exchange rate should be, or indeed what new policy instrument can take the place of a currency float. In practice, developing countries try to ensure that the real effective exchange rate, which takes account of differences in inflation in different countries, remains more or less constant over time. However, it is not clear whether this would push the current account towards equilibrium over the long term.

?The writer is a civil servant. These are his personal views