A lot of people have asked me to do a thread on the exchange rate, so here goes. I will cut some corners in the interest of speaking plainly. While my reference is Pakistan, I think what I say applies more generally to emerging market and poor countries.
A flexible exchange rate is generally thought to be better than a fixed one because of 2 major reasons. First, it helps save valued foreign exchange reserves. To run a fixed exchange rate, you need a huge amount of reserves so that you can artificially prop up your currency.
At the artificially strong fixed rate, there will b excess demand for foreign currency, which the central bank has to supply from its reserves. However, these are precious and not 2 be wasted. They are need 2 pay for imports&debt servicing. When u run low on them, u need the IMF.
Second, fixed your currency at an artificially strong rate makes imports cheaper and your exports more expensive. This put a penalty on domestic producers and results in a large current account deficit.
As I explained in a previous thread, because we have weak FDI and our banks and private companies do not borrow from abroad, the only way to fund this current account deficit is for the government to borrow from abroad, leading to a dangerous mushrooming of external debt.
So a fixed exchange rate was basically bad policy that Pak could not sustain. Instead of a fixed exchange rate, most successful countries rely on a flexible exchange rate and only intervene to supply foreign exchange from its reserves when market conditions become really unruly.
Pak moved to such a system for the first time in 2019 and deserves credit for doing so. However, notwithstanding its advantages, a flexible exchange rate can also be volatile, especially in times of stress & when a country does not have many sources of foreign currency inflows.
Therefore, 2 reduce volatility&depreciation pressures, a flexible exchange rate needs other complementary policies--prudent fiscal, monetary and trade policies and greater private sector foreign exchange inflows--as well as reforms 2 deepen the foreign exchange market over time.
I will develop these ideas in a complementary thread that discusses how the foreign exchange market works in Pak and what can go wrong. I will also go into what we need to prevent this and strengthen the Rupee over time. Coming up in another 10 minutes.
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