Analyzing the Pros and Cons of Exchange Rate Fluctuation

May 22, 2023 - Reading Time: 3 minutes - By Jewel Tete

In a recent visit to Kenya, IMF managing director Kristalina Georgieva held discussions with President Ruto and members of the Cabinet on possible policy recommendations concerning Kenya’s recovery from the exogenous economic shocks the country is experiencing. In a bid to address economic growth and inclusive development, Kenya is looking to tap into the fund’s resilience and sustainability facility which is designed to provide long-term financing to bolster economic resilience and mitigate balance of payment challenges. 

 

During these deliberations, attention was drawn to the exchange rate as a critical policy lever. A notable recommendation that emerged from these discussions was the notion of embracing a more flexible exchange rate regime, as opposed to employing artificial interventions that seek to shield it at predetermined levels. This recommendation was made based on the understanding that protecting the exchange rate by intervening in the foreign exchange market can deplete the country’s reserves. Instead, allowing the exchange rate to adjust freely is seen as a more sustainable approach due to the country’s need for reserves for imports and debt servicing.

 

This proposal has ignited discourse prompting a nuanced examination of the potential benefits and drawbacks associated with allowing the exchange rate to fluctuate freely. Such an approach can enhance market efficiency, facilitate external adjustments, and preserve the country’s valuable reserves, which are crucial for imports and debt servicing. However, there are concerns about heightened volatility, potential inflationary pressures, and the impact on trade competitiveness. In the following sections, we explore the multifaceted dimensions of this discourse, shedding light on the opportunities and challenges that lie ahead.

 

Opportunities.

Market Efficiency: 

Allowing the exchange rate to fluctuate freely enables the exchange rate to adjust more quickly to changing economic conditions, reflecting supply and demand dynamics. This can lead to more accurate pricing of goods, services, and assets, which supports efficient allocation of resources.

External Adjustment:

A flexible exchange rate can facilitate timely adjustments to external imbalances. When a country’s currency depreciates, its exports become more competitive, stimulating export growth and reducing trade deficits. Conversely, a currency appreciation can dampen excessive export competitiveness and help correct trade imbalances, supporting a more sustainable external position.

 

Preserving Reserves: 

Allowing the exchange rate to adjust naturally reduces the need for central bank intervention, thereby preserving foreign exchange reserves. This is crucial for maintaining sufficient reserves to meet import obligations, manage external shocks, and service foreign currency-denominated debt. Preserving reserves enhances the country’s financial stability and safeguards its capacity to respond to unforeseen circumstances.

 

Monetary Policy Autonomy: 

A floating exchange rate regime enhances the independence of monetary policy. It will allow the Central Bank to focus on domestic objectives, such as controlling inflation and maintaining financial stability, without being constrained by the need to defend a specific exchange rate target. This flexibility enables more effective monetary policy implementation and response to domestic economic conditions.

 

Challenges.

Volatility and Uncertainty:

A freely floating exchange rate can introduce higher levels of volatility and uncertainty in the foreign exchange market. Sharp and rapid movements in the exchange rate may create challenges for businesses, investors, and individuals in planning and decision-making. This volatility can impact investment flows, trade patterns, and overall economic stability.

 

Inflationary Pressures: 

Exchange rate depreciation can increase the cost of imported goods and raw materials, potentially leading to inflationary pressures in the economy. This can erode purchasing power, affect domestic consumers, and create challenges for price stability and monetary policy management. The Central Bank of Kenya will need to adopt appropriate measures to mitigate the inflationary impact of exchange rate movements.

 

Trade Competitiveness: 

While a significant depreciation of the exchange rate can improve export competitiveness, it can also make imports more expensive. This could affect the affordability of imported goods, machinery, and technology, potentially impacting industries reliant on imported inputs. Maintaining a balance between export competitiveness and import affordability is essential for sustaining a favourable trade environment.

 

External Debt Burden: 

Allowing the exchange rate to freely fluctuate may expose the country to greater exchange rate risk on its external debt. A depreciation of the currency can increase the local currency value of debt denominated in foreign currencies, potentially straining the government’s fiscal position and debt-servicing capacity. Effective risk management and prudent debt management practices are crucial to mitigate these risks.

 

Conclusion.

By dissecting the advantages and disadvantages of permitting exchange rate movements, policymakers and economists can engage in informed deliberations to shape a prudent and effective policy framework.

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