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Should MENA Countries Float or Peg?
Abdelali Jbili and Vitali Kramarenko
As they open up their economies, MENA countries may need to rethink their exchange rate regimes
Since the currency crises of the 1990s, economists have devoted a great deal of effort to empirical and theoretical studies of exchange rate regimes in developing countries. The initial consensus that developing countries that are highly integrated with the international trade and financial systems should adopt either a float or a hard peg is being challenged. The prevailing view now is that increasing flexibility in exchange rate management would help countries deal with external shocks, reduce the risk of banking crises, and contribute to financial stability. There are, of course, dissenters who argue in favor of intermediate regimes, stressing the difficulty developing countries have in meeting the preconditions for a successful float and the negative impact of excessive exchange rate volatility on investment and growth.
In recent years, a number of MENA countries have made considerable progress in liberalizing trade, opening up their financial systems, and adopting market-based monetary policy instruments. In light of these changes, should they also consider making their exchange rate policies more flexible? At present, exchange rate regimes in the region include a currency board (Djibouti), variants of a float (Iran and Egypt), and pegged regimes. Moreover, the six GCC members have agreed to establish a monetary union by 2010 with a single currency pegged to the U.S. dollar.
We discuss the exchange regimes of five emerging market countries in the region—Egypt, Jordan, Lebanon, Morocco, and Tunisia—and an oil-producing country—Iran—to see whether they need to consider adopting more flexible arrangements as they further open up their economies. This discussion is based on the theory of optimal currency areas, which stipulates that real shocks (for example, terms of trade shocks) are better accommodated through flexible exchange rates, and nominal shocks (for example, money demand shocks), through fixed exchange rates. Other considerations, including the size of the economy, openness to trade and capital flows, the degree of dollarization, the flexibility of labor and goods markets, trade policy, and fiscal and monetary policy coordination, are also important for the choice of exchange rate arrangement. We find that the choice of a flexible regime for Egypt and Iran is appropriate, while for other countries it is less clear-cut and more of a long-term nature. In either case, transition to a more flexible exchange rate arrangement raises the issue of what conditions countries would need to meet, including changes to their monetary policy framework, if they opted for greater flexibility.Current regimes
Based on the official classification published in the IMF's International Financial Statistics 2002, Jordan, Lebanon, and Morocco have some type of pegged exchange rate regime. Egypt had a pegged exchange rate until January 29, 2003, when it adopted a floating exchange rate regime. Tunisia and, more recently, Iran have managed floats.
Egypt pegged its currency to the dollar in 1991 but abandoned its peg in mid-2000. Pressure on the pound has increased since 1998, as capital flowed out of the country following the Asian crisis, while tourism was affected by the aftershocks of terrorist attacks at home and abroad. Moreover, the appreciation of the dollar against the euro and the yen exacerbated the loss of competitiveness. Egypt initially addressed the pressures through exchange market intervention and tighter credit policies, but official reserves continued to decline and economic growth slowed. Exchange rate pressures did not abate after an initial depreciation in mid-2000, and, in January 2001, the country adopted an adjustable currency band. However, pressures on the pound intensified again after September 11, leading to a depreciation of more than 35 percent against the dollar from mid-2000 to early 2003. Foreign currency remained in short supply in the formal market at the prevailing official exchange rate, and a parallel exchange market emerged. Following the recent move to a floating regime, the exchange rate depreciated by 20 percent, and the availability of foreign exchange in the formal market improved.
Iran adopted a managed float with a monetary aggregate as the de facto nominal anchor following the unification in March 2002 of officially recognized multiple exchange rates. The central bank operates the managed float primarily by intervening in the foreign exchange market, because the country has virtually no money markets and the financial rates of return (equivalent to interest rates) are controlled. Fluctuations in the rial's real effective exchange rate appear to be driven by oil revenues. An oil stabilization fund was recently established to help smooth out the impact of oil price fluctuations. The choice of a managed float seems appropriate, given Iran's vulnerability to terms of trade shocks, ongoing trade reforms, plans for gradual price liberalization, and prospects of large capital inflows.
Jordan, a small open economy, has had a fixed peg to the dollar since 1996. The exchange rate anchor has helped the country reduce inflation and accommodate nominal shocks to money demand but made it vulnerable to terms of trade shocks. Jordan's economy is dependent on prices of mineral exports and remittances from Jordanian workers in the countries of the Gulf. Nonetheless, it has remained competitive despite the significant appreciation of the dollar and the deterioration in its terms of trade in the past few years. This was due in part to the flexibility of Jordan's labor markets, structural reforms, a free trade agreement with the United States and an association agreement with the European Union, and the cushioning provided by in-kind oil grants from Iraq. Although private capital inflows are not large, commercial banks built up foreign assets during periods of instability to match residents' increased preference for holding foreign currency. Pressures on the dinar are addressed through a combination of central bank intervention in the foreign exchange market and interest rate adjustments. The accumulation of gross official reserves equivalent to nine months of imports by the end of September 2002 has reduced Jordan's vulnerability to shocks, while a fiscal adjustment that decreased public debt ratios has improved credibility and created room for countercyclical fiscal policy.
Lebanon also has a small open economy with a fixed peg to the dollar; its economy is highly dollarized. Although Lebanon achieved rapid disinflation during the 1990s, the economy has suffered from a loss of competitiveness and become increasingly vulnerable to the volatility of capital flows and transfers. Moreover, Lebanon's large structural fiscal deficits have led to a massive buildup of public debt (170 percent of GDP by 2001), which has made the financial system more vulnerable to any significant adjustment in the nominal exchange rate. Lebanon repeatedly had to raise its already high interest rates to defend the peg during periods of sluggish growth. Recently, intervention in foreign exchange markets has been the preferred instrument for defending the pound. This instrument has its limitations, however—in particular, if reserves are inadequate to cover foreign short-term liabilities and monetary aggregates.
The currency of Morocco, the dirham, which is pegged to a basket of currencies, appreciated, in both nominal and real terms, over a long period. With capital account restrictions (mainly on outflows by residents) in place, Morocco's central bank has preserved some monetary policy autonomy. Owing to generally prudent monetary policy, consumer price index inflation rates have converged with those of developed countries. However, the dirham appreciated by about 21 percent in real effective terms during January 1991–March 2001, mainly because of the U.S. dollar's large weight in the basket. This, together with Morocco's growing integration with the European Union, prompted the central bank to adjust the composition of the basket in April 2001 in favor of the euro, which resulted in a relatively small depreciation of the nominal effective rate. Despite the progress in macroeconomic stability, growth in Morocco has been relatively weak, reflecting the economy's dependence on agriculture and the slow pace of structural reforms. In the absence of productivity gains, the real appreciation of the dirham may have also slowed export growth.
Tunisia, which de facto targets the real exchange rate for the dinar, has enjoyed low inflation since the mid-1990s, owing mainly to prudent fiscal and monetary policies, and real GDP growth averaged 5 percent during 1996–2001. Tunisia's exchange rate policy has been facilitated by the absence of major terms of trade shocks and by capital controls for nonresidents. Tourism has become increasingly important, and dependence on agriculture has declined.
The above country-by-country analysis indicates that exchange rate regimes in the six countries had varying degrees of success. Exchange regimes in Jordan, Morocco, and Tunisia have not recently come under pressure, because real shocks were relatively manageable and macroeconomic policies were generally consistent with the choice of exchange rate regime. In contrast, the recurrent pressures in the foreign exchange markets of Egypt and Lebanon demonstrate that vulnerability to real exogenous shocks, volatile capital inflows (Egypt), and large structural fiscal deficits financed by heavy domestic and foreign borrowing (Lebanon) are incompatible with a pegged exchange rate. Regarding Iran, the exchange rate unification has been successful, and the transition to a managed float has been smooth. More time is needed, however, to fully assess this experience.
Notwithstanding the choice of exchange regime, five of the six countries (Iran is the exception) registered low inflation rates, while real growth averaged about 3–5 percent during 1993–2001. This good inflation performance mirrors the worldwide downward trend during most of the 1990s and the impact of prudent demand-management policies, as well as, to varying degrees, the persistence of price controls. The picture for growth is somewhat mixed, given the vulnerability of agriculture to weather fluctuations (Morocco and Tunisia), the volatility of oil prices (Iran), and weak improvements in total factor productivity in all six countries. In addition, international or regional exogenous shocks, including the breakdown of the Middle East peace process and the events of September 11, have affected growth. The cost of adjusting to these shocks would arguably have been smaller under a flexible exchange rate regime than under a peg, other things being equal.
Making the right choice
While the move to a more flexible exchange rate arrangement seemed to be appropriate for Egypt and Iran, it remains to be seen whether there will be more floating than managing of the exchange rate, especially given the fiscal dominance of monetary policy–making in Iran and the need to develop a supporting institutional framework for monetary and fiscal policy coordination in both countries. For the other countries, however, the need for greater exchange rate flexibility may arise in the medium or long term. Lebanon could maintain its fixed peg in the near term while implementing a strong fiscal adjustment complemented with substantial donor assistance. In the longer run, however, it is not clear whether fiscal adjustment alone—even if complemented with ambitious structural reforms—can restore competitiveness and growth to the Lebanese economy.
For Jordan, Morocco, and Tunisia, the choice of exchange regime must take into account the increase in potentially volatile capital inflows that is likely to follow trade and capital account liberalization and other reforms, and the difficulties their fledgling financial systems may have in intermediating large capital inflows. They also need to consider the real exogenous shocks to which their economies are exposed, such as changes in the terms of trade and security issues. As evidenced by the experience of other emerging market economies, more flexible exchange rate arrangements may be better suited to helping these countries adjust to increased capital inflows and exogenous shocks, whereas fixed pegs or narrow bands could have heavy economic costs, in particular if the rigidity of labor markets and nominal wages and the countries' relatively weak fiscal positions are not addressed in a timely manner.
With regard to how much flexibility is desirable and the appropriate timing of transition, there is no one-size-fits-all approach. The speed and sequencing of improvements in financial systems and progress in fiscal adjustment would be major factors, and the scope for flexibility may range from loosely managed floats to intermediate regimes. More important, perhaps, is the need for these countries to initiate the transition from the current position of relative stability without waiting for a crisis to occur.Implications for monetary policy
Countries opting for greater exchange rate flexibility need to choose a nominal anchor for their monetary policy to stabilize inflation expectations. Possible options include targeting the growth rate of a monetary aggregate or targeting inflation. Targeting a monetary aggregate such as reserve money or broad money is perhaps more familiar to policymakers in developing countries and has less stringent institutional and policy requirements. However, it is based on the assumption that the relationship between money supply and inflation is stable, which may not always be the case.
Available data on the income velocity of money—defined as the ratio of end-of-period stock of money to GDP—in the six countries show a stable declining trend, except in Jordan. But money demand could become less stable following reform of the financial sector—including the introduction of new financial instruments—and further opening up of the capital account. Moreover, unsustainable public debt, in particular in countries with a high level of dollarization, could undermine confidence, making money demand more unstable. These considerations need to be taken into account in the design of a monetary-aggregate-targeting framework.
The second option for the conduct of monetary policy under flexible exchange rate arrangements is inflation targeting. Under this framework, the central bank commits to meeting a certain inflation target in a given period and uses appropriate instruments to achieve it. It also commits to subordinating other policy objectives to the inflation target and to operating with a high degree of accountability. The central bank would adjust short-term interest rates in response to developments in expected inflation, the output gap (usually defined as the percentage deviation of actual GDP from "potential" GDP), and some measure of the exchange rate, as the latter will remain an important element for inflation targeting in open economies.
The prerequisites for the successful operation of an inflation-targeting framework are quite challenging for emerging markets. These include a sound fiscal position and a high degree of fiscal and monetary policy coordination; a well-developed financial system; central bank independence in conducting monetary policy and a mandate to achieve price stability; reasonably well understood transmission channels between monetary policy instruments and inflation; and credibility built on a solid track record of accountability and transparency.
None of the six countries meets all the requirements for inflation targeting, but Jordan and Tunisia are close to meeting certain preconditions. In particular, all sample countries need to eliminate fiscal dominance from monetary policy–making, reduce public debt and establish institutions that promote countercyclical fiscal policy, develop their financial systems, and establish credibility in fiscal and monetary policy–making. In addition, central banks need to enhance their analysis of the transmission mechanisms between policy instruments and inflation.
A number of emerging market countries, however, have moved to inflation targeting gradually, without meeting all the preconditions first. The transition to inflation targeting took place in South Africa from a monetary-aggregate-targeting framework in which inflation was an informal objective. In Chile and Poland, the transition took place through a gradual shift from targeting exchange rate bands and inflation toward focusing on inflation. This experience may provide valuable lessons for MENA countries contemplating such an approach.