Exchange rate reforms have helped support a more liberal trade regime over the last several decades. Important shifts have included widespread currency convertibility, the move toward unified exchange rates, and the increased adoption of flexible exchange rates. The latter was particularly helpful during the Great Recession, when countries with floating currencies appear to have taken fewer protectionist measures than did those with fixed exchange rates, and several countries switched from a pegged to a floating regime.
Nevertheless, certain characteristics of the international monetary system—and the ways that countries take advantage of them—continue to hinder trade. Some countries with pegged exchange rates, for example, tend to have the most restrictive trade regimes. Moreover, those with heavily managed exchange rates that are also perceived to have undervalued currencies, beginning with China, present an obvious source of trade tensions.
Exchange Rate Rationalization and Open Trade Have Gone Hand in Hand
Historically, non-convertible currencies―currencies that cannot be readily exchanged for another currency to make payments and transfers―have hampered trade. Before establishing currency convertibility in 1958, for example, European economies entered into hundreds of clearing agreements1 with one another. These agreements were one symptom of large transaction costs that undermined the growth of trade. Studies have also shown that exchange controls reduce exports.
Meanwhile, dual/multiple exchange rates—that is, different official exchange rates for different international transactions, with one rate for essential imports and another for luxury imports, for example—led to black markets for foreign exchange, creating inefficiencies and further complicating international transactions.
Over the last several decades, however, countries have moved toward current account convertibility and unified exchange rates, facilitated by the IMF and improved international coordination. Under today’s system, 90 percent of IMF member countries have convertible currencies for current account transactions (up from 30 percent in 1970), and only fourteen countries have dual or multiple exchange rates (down from 40 in 1984).
These moves have helped to facilitate trade by lowering transaction costs. They have also often been the precursors to trade liberalization in many countries. Three years after European countries adopted current account convertibility, for example, most removed restrictions against U.S. exports. The majority of developing countries, which retained current account restrictions until the 1980s and 1990s, followed a similar pattern. After China introduced current account convertibility and a unified exchange rate in 1993–1994, its average import tariffs fell from 40 percent in 1992 to 17.6 percent in 1997. In India, similar changes from 1994–1996 led average import tariffs to drop from 94 percent in 1992 to 34 percent in 1997.
The importance of flexible exchange rates in containing protectionism is illustrated by comparing crisis experiences, when protectionist pressures are strongest. Protectionism was contained during the recent financial crisis, in contrast to the Great Depression, when most currencies were still pegged to gold. To be sure, this success owes much to other factors, including countercyclical macroeconomic policies, World Trade Organization (WTO) disciplines, difficult-to-change open national trade regimes, and regional agreements, as well as structural changes that have made trade more pervasive. But the more flexible international monetary system also helped.
Flexibility and Protectionism
Countries are today free to choose whether to peg or float their rates, and about one-third of economies—which account for nearly 80 percent of world GDP—have chosen flexible exchange rates. In these countries, exchange rates function as shock absorbers, helping them deal with financial shocks and continually adjust competitive positions to differences in inflation and the business cycle. Nearly 20 percent of countries with less-flexible arrangements switched to more-flexible regimes over the course of the crisis.
This appears to have helped limit protectionism during the Great Recession, as countries relied on movements in their exchange rates rather than protectionist measures to stabilize domestic economic activity.
Exchange rate volatility increased during the crisis but without inducing big changes in competitiveness in most countries over the course of the crisis. The month-to-month (m/m) change in the dollar exchange rate in 40 major exporting countries peaked at 7.4 percent during the crisis (compared to a maximum of 2 percent in the three years before the crisis). However, the real effective exchange rate (REER) of nearly 60 countries (for which comparable data is available) depreciated or appreciated by more than 5 percent in only nine countries.
In addition to mitigating the need to restrict trade in the countries under the greatest pressure, flexible currencies also seem to have kept countries from resorting to competitive devaluation. According to the Global Trade Alert, only five countries—Nigeria, Vietnam, Kazakhstan, Venezuela and Ethiopia, all relatively small exporters—engaged in competitive devaluation during the crisis.
Countries with pegged rates, on the other hand, tended to resort to trade restrictions a little more frequently (see chart below), echoing the experience of strict adherents to the the gold standard during the Great Depression. For example, Ecuador (which adopted the U.S. dollar as its currency in 2000) responded to a widening current account deficit in 2009 by announcing import restrictions that affected 23 percent of its imports—far higher than the less than 1 percent of world trade affected by protectionist measures during the crisis.
Ecuador is just one example. Countries with fixed-exchange-rate regimes account for 64 percent of all countries in the world, but 75 percent of the countries that have implemented trade discriminatory export subsidies and 70 percent of those that have implemented tariff measures since January 2008. And, more generally, countries with flexible exchange rates tend to have less restrictive trade regimes. For example, of the 30 countries that have the most restrictive trade regimes according to the World Bank’s Trade Restrictiveness Index, only six have flexible exchange rates.
Certain countries that peg their currencies at rates that are widely perceived to be undervalued, including China, present a special problem, heightening trade tensions and becoming targets of retaliation. For example, the United States has significantly increased the antidumping (AD) and countervailing duties (CVD) it imposes on China in recent years, particularly as a share of total U.S. ADs and CVDs. The sharpest and most sustained increase occurred after the renminbi became a target of international complaint for being undervalued.2
Moreover, numerous developing countries continue to employ significant foreign exchange restrictions. In 2008, the IMF identified about 30 developing economies that maintained exchange restrictions, from limits on payments for current transactions to requirements of prior approval for business-related transactions. Such restrictions reinforce trade barriers, hamper domestic trade reforms, and limit the gains from international trade integration.
Conclusion
While more flexible exchange rate regimes are often a companion to an open and predictable trading system, one size does not fit all. A range of considerations, including a high degree of openness, weak financial institutions, and reliance on a single commodity export, leads some countries to prefer a pegged exchange rate regime. Moreover, a pegged exchange rate and a very open trade regime can coexist, as exemplified by Hong Kong, which has pegged its currency tightly to the dollar over decades but has no tariffs.
However, economies that have large domestic markets, diversified exports, and play a systemically important role, notably China, would be well advised to adopt more flexible currencies. This is not only in their interest—allowing monetary policy to target domestic demand as their financial markets become more integrated with those in the rest of the world—but would also help preempt trade tensions and ensure the smooth functioning of the international monetary system.
Uri Dadush, author of the book Juggernaut, is the director of Carnegie’s International Economics Program. Shimelse Ali is an economist in Carnegie’s International Economics Program. Rachel Esplin Odell is a Junior Fellow in Carnegie’s Asia Program.
1. Clearing agreements represent trade using “book” money and provide liquidity and credit to countries with inconvertible currencies.
2. This occurred in 2003—the year that significant undervaluation of the RMB is estimated to have begun and the first year that the RMB became a target of international complaint. See Cline and Williamson (May 2011) and Bottelier (2010).