Introduction
Globalization; a well known phenomenon throughout the world has escorted to a crucial continuance in increasing international trade (movement of goods between different countries). This gives countries like Maldives an opportunity to be exposed to goods and services in the international market. Maldives is small and an import oriented economy, where around 75% of the economy depends on imports. In order to trade, exchange of money takes place based on a particular exchange rate. Therefore an exchange rate could be defined as “the price at which the national currency is valued in relation to a foreign currency” (Latter, 1996, p.9).
Fixed exchange rate regime was the exchange rate policy used in Maldives previously. At that time the exchange rate was 12.85 Rufiyaa per US Dollar (MMA, 2011). In April 2011, there was a shift from fixed exchange rate to a managed floating exchange rate. The central bank or the MMA did not leave the exchange rate wholly to market forces. It means the MMA is having some degree of intervention into the market. With this change, now the exchange rate is authorized to fluctuate within a band. The midpoint of the band is 12.85 and there is an increase and decrease of 20 percent from 12.85. That is between 10.28 Rufiyaa and 15.42 Rufiyaa (MMA, 2011).
Exchange rate policy has been labeled as one of the most significant up-and-downs in the economies of developing countries. There are different theories used for forecasting the movement of exchange rate. However, there is not any best theory as different countries are having different economic environments. There are two discrete types of exchange rate; fixed exchange rate (“a type of exchange rate regime wherein a currency’s value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold” (Wikipedia, 2011)) and floating exchange rate (“a market-driven price for currency, whereby the exchange rate is determined entirely by the free market forces of demand and supply of currencies with no government intervention whatsoever”(articlesbase, 2007)).
Why choose a floating exchange rate?
In theory, a floating exchange rate allows an automatic balance of payment amendments. For example, if a country is having a balance of payment deficit then the depreciation of currency should take place. As depreciation leads to making exports cheap and imports more expensive, accordingly demand for home goods will increase and demand for foreign goods will decrease following a decrease in balance of payment deficit. Conversely, to abolish the balance of payment surplus currency should be appreciated.
In addition to this, floating exchange rate permits the monetary authorities more freedom to use interest rate as a monetary tool to manage domestic economy. This helps to protect the domestic economy from world economic fluctuations. For example, in 1992 UK moved to a floating exchange rate system and this allowed a high cut in interest rate. As a result UK was able to come out of a prolonged recession (Tutor2u, n.d).
Moreover, floating exchange rate is a more accurate reflection of the value of the currency. It will reduce the trading of domestic currency in the black market comparing with times when the currency was fixed too high. For example, introducing exchange rate in Seychelles in the year 2008 resolved the black market exchange (IMF,2011).
Other than these, floating exchange rate lowers the foreign exchange reserves. When the exchange rate is fixed, a country will have to hold large amounts of foreign currency. This is done in order to defend the fixed rate. These reserves have a high opportunity cost on the economy. For example, reserves can be used in giving subsidies.
Why avoid floating exchange rate?
According to the J curve effect, automatic balancing of balance of payment depends on the elasticity of goods which a country imports. For example, Maldives is depending on imports. Therefore the price elasticity of demand for imports is very low; people do not have an alternative. So no matter how expensive foreign goods are they consume imported goods causing a deficit in current account and also it creates a high inflation in domestic economy.
A floating exchange rate can worsen the inflation. If a country is having a high inflation rate compared with others, this in turn reduces the export of that country. For example, in Maldives it now costs more than before to produce a can of tuna. Therefore the trading partners of Maldives may turn to other countries which produce tuna that are cheaper with low rates of inflation. Loss of competitiveness worsens the current account balance.
Furthermore, floating exchange rate creates uncertainty for the businesses and it might reduce the domestic investment and the foreign investment (Foreign Direct Investment). For example, a business about to invest in building a yacht, under a fixed rate, the investor knows exactly how much it will cost in Rufiyaa because the rate is fixed. In contrast, under a floating system the price will change daily so that the final cost would be much higher than previously expected. This will discourage the investors.
A look back on the Maldivian Exchange rate
According to MMA, Maldives joined International Monetary Fund (IMF) in 1978 (n.d). With the support and help from IMF, on 1st July 1981 Maldives Monetary Authority (MMA) came into existence (MMA, n.d). The main duties of MMA were to check the availability of money, providing the money supply and to adjust the value of money. Therefore the exchange rates were fixed by the MMA from that year itself. Exchange rate was there even before the existence of MMA. The following graph (figure 1.1) shows an overview of the exchange rates in Maldives from 1960 to 2008.
Source: International Financial Statistics (IFS) of IMF
Comparison
According to Meltzer, till august 1971 Japan sustained a fixed exchange rate. After the collapse of Bretton Woods system, in 1985 and also due to a high inflation in the economy, Japan adopted a managed market economy where there is some degree of interference by the central bank (n.d). This change in exchange rate brought a vast improvement in Japanese economy. These improvements include a stable economic growth, decline in inflation and low unemployment (Meltzer, n.d).
After the introduction of Australian currency, they maintained it under the Bretton Woods system. It is a fixed exchange rate done by using the Dollar standards (Wikipedia, 2011). With the breakdown of Bretton Woods system, Australia moved from a fixed exchange rate to a floating exchange rate in 1983 (Wikipedia, 2011). This change brought positive economic effects into the economy. The positive effects include appreciation of Australian Dollar and an increase in economic growth.
Seychelles maintained a fixed exchange rate till 2008. According to IMF, Seychelles was facing numerous economic problems like balance of payment debt crisis, decrease in living standard, decrease in economic growth, black market exchange and so on (2011). Therefore with the help and suggestions by the IMF, Seychelles shifted its fixed exchange rate system to a floating exchange rate system (IMF, 2011). This intern caused several progresses in Seychelles economy. The progresses include resolution of black market exchange, improved economic growth, improved balance of payment and so on (IMF, 2011).
From recent years, Maldives is having indiscipline fiscal policy. This got worsen after the tsunami in 2004. According to IMF (2009), due to the tsunami, government expenditure increased to 60 percent of GDP (Gross Domestic Product) in 2008. The global recession was mid- 2008. This lead to weakening the balance of payment as the tourism industry was hard hit because of the global recession. At the same time world oil prices increased causing an increase in inflation in the economy. In order to overcome these economic problems, change in exchange rate occurred.
Procedure
A survey form was given to locals who have some idea about the exchange rate. In order to get accurate and valid results, it was important to select the people having knowledge about the topic. Some options were given in survey form and also they were being asked to write their own views, if they had any. For further information refer to appendixes of this document.
Result
In this survey around 25 people were asked about their views. Results are done based on their views, whether they are in favor of the change or not. The results are shown below in figure1.2.
DiscussionsMundell-Fleming model argues that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave third to the market forces. As for examples, recently most of the countries started moving from a fixed exchange rate to a floating exchange rate. Most major currencies are having a floating policy including US dollar, Yen and Euro.
In favor of the changeInternational Monetary Fund (IMF) has admired the decision of floating the exchange rate in Maldives. “Today’s bold step by the authorities represents an important move toward restoring external sustainability” (IMF, n.d). “IMF staff support this decision made by the authorities. We remain in close contact and are ready to offer any technical assistance that they may request” (IMF,n.d). Therefore it is argued that IMF would not guide a country in a wrong path.
Floating exchange rate gives more accurate value of Rufiyaa than in fixed exchange rate. This is because in floating system, value of Rufiyaa is determined by the market forces of demand and supply. Due to the artificial fixed exchange rate of Maldives, economic development minister argued that “we do not really know, based on the breadth of the economy, what the value of the Maldivian Rufiyaa is right now” (Robinson, 2011).According to finance minister Ahmed Inaz, the reason for this modification is to form government policy in such a way to increase the value of Rufiyaa and to bring down the exchange rate to Rufiyaa 10 (Robinson, 2011).
Also Floating exchange rate will overcome the Dollar shortage crisis. This is because the rate will stabilize at the point where the supply equals demand. Therefore market will not leave any gap. Maldivians have been facing Dollar shortage problems from recent years. This happened because of the excess amount of Rufiyaa in the market than that of the amount of Dollar. Therefore, people will be having more Rufiyaa to demand for Dollar. As a result demand for Dollar increased causing a shortage. According to Ahmed Shiyam Mohamed(chairman of Suntravels) shortage of Dollar in Maldives is not due to low foreign income into the country, but it is due to the excess 300 billion Rufiyaa which was printed by the government from 2004 to 2009(Latheef, 2011).
Against the change
Due to floating exchange rate, Rufiyaa has been devalued, at least in the short-term. As a result import price increases. Therefore the floatation adds both imported inflation and domestic inflation to general price level. For example, three months ago a can of Enfalac (baby milk) 900g was for 275 Rufiyaa, but now the price is 325 Rufiyaa. Therefore there will be a huge impact on the general public due to this inflation.
In theory, a floating exchange rate solves the foreign exchange shortage problems, but it actually depends on several factors. For instance, Maldives is not having any legislation to control foreign exchange (MMA, 2011). There is no restriction on imports of capital goods for both locals and foreigners. Everyone is free to import. And also locals are liberated to maintain their foreign currency accounts anywhere they want. In this case, what Maldives get as foreign income will not be available in the market, creating a shortage.
A floating exchange rate resolves the black market exchange. However, this cannot be applicable in all the situations. In Maldives there was a Dollar shortage. Due to this black market exchange was active. In order to do this floatation government did not inject any amount of extra Dollar into the market. It means government did float the demand, but not the supply. As a result the black market exchange still continues.
Conclusion
As mentioned before, exchange rate is labeled as the most significant up and downs in the economies of developing countries. Without fiscal stability, financial stability and monetary stability, no exchange rate system can function well in the economy. Therefore, for a country like Maldives it is important to smooth the progress of more efficient functioning of the market. This can be done by a good law enforcement strategy and also by reducing the dependence on Dollars. At the same time it is important to think about the long run rather than thinking about the short run. An economic policy cannot show its effect within few days. Therefore it needs strong support from all parties in the economy.
