Exchange rates and capital mobility

A major change in the organisation of international finance occurred in the latter years of the twentieth century, and economists are still debating its implications. At the end of the second world war the national signatories to the Bretton Woods Agreement had agreed to maintain their currencies each at a fixed exchange rate with the United States dollar, and the United States government had undertaken to buy gold on demand at a fixed rate of $35 per ounce. In support of those commitments, most signatory nations had maintained strict control over their nationals’ use of foreign exchange and upon their dealings in international financial assets.

But in 1971 the United States government announced that it was suspending the convertibility of the dollar, and there followed a progressive transition to the current regime of floating exchange rates in which most governments no longer attempt to control their exchange rates or to impose controls upon access to foreign currencies or upon access to international financial markets.

The behaviour of the international financial system was transformed. Exchange rates became very volatile and there was an extended series of damaging financial crises. One study estimated that by the end of the twentieth century there had been 112 banking crises in 93 countries, another that there had been 26 banking crises, 86 currency crises and 27 mixed banking and currency crises – many times more than in the previous post-war years.

The outcome was not what had been expected. In making an influential case for flexible exchange rates in the 1950s, Milton Friedman had claimed that if there were any resulting instability, it would mainly be the consequence of macroeconomic instability, but an empirical analysis in 1999 found no apparent connection. Economists began to wonder whether the expected advantages of freeing financial markets from government intervention were in fact being realised.

Neoclassical theory had led them to expect capital to flow from the capital-rich developed economies to the capital-poor developing countries - because the returns to capital there would be higher. Flows of financial capital would tend to increase the level of investment in the developing countries by reducing their costs of capital, and the direct investment of physical capital would tend to promote specialisation and the transfer of skills and technology.

However, theoretical considerations alone cannot determine the balance between those benefits and the costs of volatility, and the question has had to be tackled by empirical analysis.

A 2006 International Monetary Fund working paper offers a summary of the empirical evidence. The authors found little evidence either of the benefits of the liberalisation of capital movements, or of claims that it is responsible for the spate of financial crises. They suggest that net benefits can be achieved by countries that are able to meet threshold conditions of financial competence but that for others, the benefits are likely to be delayed, and vulnerability to interruptions of capital flows is likely to be increased.

Although the majority of developed countries now have "floating" exchange rates, some of them – together with many developing countries – maintain exchange rates that are nominally "fixed", usually with the US dollar or the euro. The adoption of a fixed rate requires intervention in the foreign exchange market by the country’s central bank, and is usually accompanied by a degree of control over its citizens’ access to international markets.

A controversial case in point is the policy of the Chinese government who had, until 2005, maintained the renminbi at a fixed rate to the dollar, but have since "pegged" it to a basket of currencies. It is frequently alleged that in doing so they are deliberately holding its value lower than if it were allowed to float (but there is evidence to the contrary).

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WHAT IS FOREIGN EXCHANGE INTERVENTION?