David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

29.5 Fixed vs floating
Financial discipline
Floating exchange rates let different countries pursue different inflation rates indefinitely. Exchange rates
of high-inflation countries depreciate to maintain purchasing power parity and constant competitiveness.
Critics of floating exchange rates argue that they do not provide any financial discipline.
In contrast, with a fixed exchange rate, countries become uncompetitive if they have above-average
inflation. Unless allowed to devalue, they eventually have no choice but to adopt more restrictive domestic
policies to get their inflation rates back in line with the rest of the world.
Fixed exchange rates, however, are not the only route to financial discipline. Instead, the government can
make domestic commitments about monetary policy. In recent years, many countries have made their
central banks operationally independent of government, giving them freedom to decide interest rates in
pursuit oflow-inflation targets laid down by the government.
Domestic commitments are not always foolproof. But exchange rate commitments are no certainty either.
The weaker EMS currencies (sterling, the lira, the peseta, the escudo) could not maintain previous fixed
exchange rate commitments in September 1992, and by 2010 financial markets were beginning to wonder
whether the PIGS could survive inside the eurozone.
There is now mounting pressure on China to abandon its peg to the US dollar, which has been maintained
at a level that has left China supercompetitive. If China is running a vast current account surplus, only two
outcomes are possible. The first is that its balance of payments is broadly in balance, in which case it is
experiencing a capital outflow of similar size to its current account surplus; but it is paradoxical that rich
countries such as the US are therefore borrowing from China whose standard of living is so much lower.
The other possible outcome is that China does not have a massive capital account outflow, in which case
its current account surplus will imply an overall balance of payments surplus, and a huge monetary inflow
into the country which, sooner or later, will cause domestic inflation that gradually erodes Chinese
competitiveness again.
Table 29.2 shows the recent balance of payments performance of emerging Asian economies as a whole, a
group that includes China and India. The group has been running a current account surplus of between
$400 billion and $500 billion per annum. The combination of private sector capital flows and other capital
flows has also contributed to an inflow. Hence, the combined balance of payments of this group of countries
has exceeded $500 billion a year.
What is happening to this monetary inflow? It is adding to the foreign exchange reserves of these countries.
Are they floating or fixing their exchange rates? If they were floating, the overall balance of payments
would be zero. They are fixing, and the level of the peg is below the exchange rate that would deliver
external balance. Putting it differently, if they were now all to float, on average their exchange rates would
appreciate and their competitiveness would decline.
Table 29.2
Emerging Asia, balance of payments, 2008-10 (Sbn)
2008 2009
Current account +420 +481
-
Capital account +2 14 +34
Balance of payments +634 +5 15
Growth in forex reserves +634 +5 15
201 0
+469
+57
+526
+526
Source: IMF.
667