RSS FeedBy M. Isi Eromosele
There is a broadly held view in some financial circles that adjustable pegs and currency bands may not be feasible in a global market of unpredictable capital movements. Fragile domestic capital systems have been adversely affected by stress from capital flow reversals, particularly bank lending.
Emerging markets tend to experience more currency devaluations that in developed markets, especially after a harsh currency crisis. Inadequate risk management practices result in banks and private corporations in emerging markets experiencing balance sheet shortfalls.
The depreciation of exchange rate adds to the debt load of these institutions, which then raises the scepter of a monetary crisis. The vulnerability in the financial sector intensifies when there is abrupt exchange rate depreciation. This would cause the credit ratings of emerging markets to be downgraded, which in turn squeeze their access to the global lending market.
There is a lack of any ordinary orientation point to which parity can return to after a financial crisis. As such, this kind of uncertainty causes volatility in emerging market exchange rates. The gold standard used to be regarded as an unofficial orientation point, which countries were supposed to give back after financial upheavals. As a result of the termination of the Bretton Wood system, no new orientation points have been established.
Small market economies which are close to sizeable currency areas may apply the dollar or currency boards as a point of orientation. They may, however encounter severe execution obstacles if they choose a fixed peg, which requires the support of constitutional law or international law. Choosing a suitable currency as a point of orientation is hard. In order for flexible exchange rates to be credible, thereby encouraging financial stability, it must be established by a self-governing central bank.
The exchange rates in emerging markets that are without official orientation points have narrow flexibility because their Central Banks may not allow the floating of its exchange rate. In large economies, where the capital within internal financial markets has depth, a floating exchange rate is acceptable. Emerging markets, whose commodities are very exposed in foreign trade and whose internal market is low cannot execute a floating currency exchange.
Real exchange rate targeting is still practiced in many emerging markets. However, the frequency of capital movements makes this practice very hard to execute. Additionally, as unpredictable as they are, real exchange rates are prone to long term drift after a short period of time. Furthermore, domestic and international rates are equally responsive to either floating exchange rates schemes or fixed one. It can be comfortably asserted that the theoretical benefits accrued under a floating rate scheme had been overrated.
Fundamentally, the administration of emerging market exchange rates under free floating policy can result in unnecessary domestic price instability in their finance and trading sectors. Using the dollar as an orientation point had previously failed because it was not helpful to expansive trade models and free monetary policies. During past periods of financial instability, currency boards experienced the imperfections of pegged schemes. The ultimate outcome then was that many emerging markets had to borrow to cover their losses and maintain their liquidity.
The governments of emerging markets should have the flexibility to choose exchange rates they believe would be best for them and not have one imposed on them. It is imperative that the global financial world recognize that the financial markets of emerging economies are not yet developed enough to fully depend on private capital for financing.
An intermediate rates scheme needs to be set up, aggressively supported by carefully constructed regulations to help limit currency speculative attacks that hurt the economic development of emerging markers.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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