EXCHANGE RATE EVOLUTION
EVOLUTION OF EXCHANGE RATE DETERMINATION IN MALAWI:
PAST AND PRESENT
The management of exchange rate in Malawi has been pursued with three
major policy objectives in mind.These include:
i. attainment of growth in real income;
ii. maintenance of a viable balance of payments position; and
iii. attainment of stable domestic prices.
These objectives were attained to some extent in the 1970s; but, owing
to both external and internal factors, they were difficult to achieve in
the 1980s.In this section, we look at the evolution of the exchange rate
in Malawi by focusing on periods identified as first the par value peg to
the British pound sterling; second, the peg to the trade-weighted basket
of the US dollar and the British pound; third, the peg to the SDR; fourth,
the peg to a basket of currencies; and finally the floating regime. The
analysis of recent developments will follow.
(a) British Pound Sterling/Malawi pound par value system (1965-1973)
The use of the exchange rate as an instrument of monetary policy began
as early as 1965 when the Reserve Bank of Malawi became fully
operational.Soon after attaining self rule from Britain in 1964, Malawi
introduced its own Malawi pound, which later became known as the Malawi
kwacha in early 1971.At that time the Malawi currency was pegged at par to
the British pound sterling and this continued until November 1973. During
this period (1965-1973), the Malawi pound moved in tandem with movements
in the British sterling, such that when the latter was devalued by some 14
percent in November 1967, the Malawi pound was also devalued by the same
magnitude. During that time the Malawi pound was floating against the US
dollar and commercial banks calculated rates for other currencies with
reference to London Inter-bank Market rates. During this exchange rate
regime, the Malawi economy enjoyed buoyant economic growth and had a
healthy balance of payments position.
During this period, many developed countries including the United
Kingdom, maintained a fixed exchange rate system with the gold or the US
dollar. [1]
[2] By
1971 problems arising from limited gold supply[3]
began to surface; and, by 1973 this system completely collapsed as most
major countries renounced the par value system. This was followed by the
generalized floating of exchange rates by several countries, which caused
large volatilities in currency markets. The Malawi currency, as was
expected, depreciated along with the depreciation of the British pound to
which it was pegged. Authorities, thus, began to think of other ways of
managing the exchange rate.
(b) Peg to weighted Basket of British Pound and the US dollar
(1973-1975)
From November 19, 1973, Malawi authorities responded to the movements
in the international currencies by de-linking the Malawi kwacha from the
British pound, and pegging it to a trade-weighted basket of the British
pound and the US dollar. In this system, the Reserve Bank determined the
exchange rate by setting daily buying and selling rates for the US dollar
and the British pound in the light of foreign exchange market
developments. During this period, which ended in June 1975, authorities
started pursuing an active exchange rate policy, which involved overt
(announced) devaluations of the kwacha when a need arose.
(c) The Peg to the IMF SDR (1975-1984)
With effect from 9 June 1975, the Malawi kwacha was pegged to the IMF's
Special Drawing Rights (SDR) initially at the rate of MK1.0540 to one
SDR.The middle rate for the US dollar was determined on the basis of the
IMF's daily calculations of the US dollar-SDR rate; rates for other
currencies were determined on the basis of cross rates on the London
inter-bank market. This time the US dollar was used as the intervention
currency.
For a time, the peg to the SDR seemed to have worked better for the
economy as evidenced by the temporary stability achieved with the new peg
at a time when major international currencies were experiencing violent
movements. These benefits, however, proved to be only short-lived as the
SDR began to appreciate in chorus with the US dollar [4]
in the early 1980s. The Malawi kwacha responded by appreciating along with
the SDR. This did not go well with Malawi authorities as it constrained
export development.
It must also be recalled that at the beginning of the 1980s, Malawi's
sound economic performance was seriously disrupted by several shocks, both
from external and internal sources.One of the external factors was
deterioration in the country's terms of trade, which resulted largely from
weak external demand for the country's primary products in world
markets.As the SDR continued to appreciate, Malawi authorities had to take
active exchange rate actions with the view to restraining the terms of
trade from further deterioration.Hence on April 24, 1982 the kwacha was
devalued by 15 percent. This was followed by another devaluation of 12
percent on 17 September 1983. These actions, however, failed to redress
the situation as the country was also severely affected by a drought,
which curtailed agricultural production, thereby adding pressure on the
country's balance of payments.
(d) Peg to the Weighted-Basket of Seven Currencies (1984-1994)
Despite the devaluations carried out in 1982 and 1983, the country's
external situation continued to deteriorate, which was made even worse by
the disruption of the traditional transport routes to the maritime ports
of Beira and Nacala due to political conflicts in Mozambique.On 17
January, 1984 authorities de-linked the Malawi kwacha from the SDR and
pegged it to a trade weighted-basket of seven currencies [5]
representing the geographical composition of Malawi's trade and the
currencies used in settling the country's international transactions.
During this regime, the middle rate of the Malawi kwacha exchange rate as
quoted by the Reserve Bank was determined on the basis of the daily
calculations of the exchange rate of the US dollar in terms of the SDR.
Rates of other currencies were quoted by the Reserve Bank on the basis of
the appropriate daily cross rates as communicated by the IMF. Frequent
adjustments were made with the view to realigning the kwacha with the
basket taking into account inflation differentials.
Although the peg to the trade-weighted basket of currencies managed to
improve the current account balance from -11.8 percent of GDP in 1983 to a
low of -1.7 percent in 1984 (Table 1 appended), problems on the
international trading routes intensified when Beira and Nacala routes were
completely closed to Malawi traffic in 1984.This forced the country to
rely on long overland routes to the ports of Durban in South Africa and
Dar-es-Salaam in Tanzania, a change which significantly increased the
country's c.i.f. / f.o.b. [6]
margin from only 22 percent in the 1970s to over 40 percent since 1984.
This worsened the country's terms of trade. Authorities had to take active
exchange rate changes. Thus on April 2, 1985 the kwacha was devalued by 15
percent; it was devalued by 10 percent on August 16, 1986; by 20 percent
on February 7, 1987; by 15 percent on 16 January 1988; by 7 percent on 24
March 1990; and twice in 1992, by 15 percent on March 28 and 22 percent
July 11.
(e) Floatation of the Malawi kwacha (February, 1994)
In 1988, the Malawi government embarked on a three-year structural
adjustment program supported by the IMF’s Structural Adjustment Facility
(SAF), the World Bank's Industrial and Trade Policy Adjustment Credit (ITPAC)
and the Agricultural Sector Adjustment Credit (ASAC).Among other things,
this program involved a phased liberalization of imports, that is the
removal of restrictions on the approval and availability of foreign
exchange for private sector imports, as well as a move towards adoption of
a more flexible exchange rate policy.
On February 7, 1994 the foreign exchange market was completely
liberalized and the kwacha was allowed to float freely. Several factors
led to this change, including: fundamental disequilibrium as revealed by
balance of payments pressures emanating from the 1992/93 drought; the
withdrawal of non-humanitarian development assistance by the international
community on account of ''good governance'' issues; and by the fact that
several member countries of the then Preferential Trade Area (PTA) now
COMESA had already adopted various types of market-determined exchange
rates.
To support the liberalization, other measures were also implemented in
1994. A foreign exchange retention scheme whereby exporters of
non-traditional exports were allowed to retain a major portion of their
export earnings was instituted.Further more,exporters of traditional
exports, i. e.tobacco, tea and sugar were allowed to open interest earning
foreign denominated accounts with domestic banks.These measures were meant
to encourage production for export. In addition, restrictions on capital
movements by non-residents were also removed, and foreigners were
permitted to make direct investments and buy market-traded paper and
repatriate investment proceeds without any restrictions.
The switch from the fixed regime to the floating one was meant to
achieve certain objectives, which can be summed up as:
(a)improvement of the country's export competitiveness;
(b)provision of an efficient foreign exchange allocation mechanism;
(c)dampening speculative attacks on the kwacha; and
(d)restoration of both investor and donor confidence; among other
objectives.
The following features were also put in place to support the foreign
exchange market liberalization:
(a) authorized dealer banks were free to buy and sell foreign exchange
at freely determined market exchange rates;
(b) foreign exchange bureaus were authorized to engage in spot
transactions with the general public on the basis of exchange rates
arrived at with their clients;
(c) foreign exchange brokers [7]
were authorized to match orders from buyers and sellers of foreign
exchange on agency basis only;
(d) to determine the exchange rate, the Reserve Bank convened weekly
fixing sessions at which offers to buy and sell foreign exchange from
authorized participants were matched to arrive at a clearing exchange
rate. Thus the type of the free float adopted was the auctioning system;
and
(e) exchange rates of other currencies were determined on the basis of
the cross rates of the US dollar for the concerned currencies.
There are many advantages for floating a currency. One is that a
floating currency ensures that movements of the exchange rate are in line
with the market forces of demand for and supply of foreign exchange. In
this case, the foreign exchange value of the domestic currency settles at
a price, which equates the quantity of foreign exchange demanded to the
quantity supplied. Just like in any other free market, if the amount of
foreign exchange supplied in the foreign exchange market falls short of
the amount demanded, the price of the foreign exchange rises until the
quantity demanded is equal to the quantity supplied. The reverse occurs
when the quantity supplied exceeds the quantity demanded.
(e) Recent Developments in the Malawi Kwacha Exchange Rates
When authorities floated the Malawi kwacha on 7 February 1994, the
currency immediately plummeted, from its level of K6.70 per US$1.0 on
Friday, 4 February to K9.88 per US$1.0 on 28 February 1994, a loss of 32.2
percent within a period of one month. This resulted from a combination of
factors, such as the liberalization of the foreign exchange market and the
1992/93 drought. By end-November of that year, the kwacha had depreciated
in nominal terms by over 290 percent against the US dollar; 300 percent
against the British pound; 279 percent against the South African rand; and
335 percent against the German mark, reflecting spending overruns which
led to loss of confidence in the kwacha. Initially, such massive
depreciations were viewed as excessive. In fact the general consensus was
that the depreciation was more than what was implied by the economic
fundamentals.
Increased government expenditures following the 1994 general elections
triggered a rapid acceleration in inflation which reached critical levels
in 1995 and 1996. During this period exchange rate policy focused on
reducing price increases. Although authorities managed to curb
inflationary pressures during the last half of 1996, there were
indications that the real exchange rate was appreciating, which was not in
the best interest of the country's long term growth prospective. Besides
the fact that foreign exchange was readily available during most of 1996,
the appreciation of the real exchange rate was caused by domestic
developments in the South African economy that saw the rand nose-diving
against the US dollar. This affected the Malawi kwacha since Malawi has
strong trade links with South Africa.
Despite these developments, the nominal value of the kwacha remained
relatively stable, especially vis-à-vis the US dollar during most of 1996
and the first half of 1997. However, this stability also meant that the
real exchange rate strengthened over the same period and became
excessively overvalued, mainly reflecting huge inflation differentials
between Malawi and its trading partners. This, combined with pressures on
the currency arising from huge fiscal deficits in the second half of 1997,
led to the devaluation of the kwacha in July 1997. At the same time,
authorized dealers (except bureaus) were now required to maintain the
by-sell spread of not more than 2 percent.
The devaluation of the kwacha in July of 1997 had the effect of
improving its competitiveness vis-à-vis currencies of the country’s
regional trading partners, but this was only temporary. The currency began
to appreciate in real terms against the Zimbabwe dollar and the South
African rand. This trend continued into the second half of 1998.
South Africa and Zimbabwe account for a considerable proportion (about
60 percent) of Malawi's trade (mainly imports); hence the fall in value of
the rand and the Zimbabwe dollar in 1997 and 1998 rendered the kwacha
uncompetitive. Furthermore, pressures on the kwacha intensified at the
beginning of the second half of 1998 as indicators revealed that tobacco
exports and donor-related inflows were going to be much lower than
expected at the beginning of the year. As a result the reserves target
could hardly be attained. To make matters worse, demand on official
reserves which normally emerges in October, began as early as August and
this was a clear indication that reserves management thereafter would
become increasingly difficult.
It was against this background that authorities decided to take
appropriate exchange rate action. Consequently, the kwacha was devalued by
28 percent and 23 percent on 21 and 24 August, respectively. This action
resulted in a real depreciation of the kwacha and the demand on official
reserves appreciably decreased.
Towards the end of August 1998, the kwacha was allowed to be market
determined again and intervention by the Bank was only guided by preset
reserves target. However, over this period, the exchange rate system was
more of a managed float with banks trading with few limitations. The
Reserve Bank remained the main dealer.
From August 1998 to December 1999, the nominal exchange value of the
kwacha ranged between K42 to a US dollar and K46.
In the final analysis, it must be mentioned that the maintenance of a
stable exchange rate in the short-term requires many things, including
first the maintenance of adequate foreign reserves for currency
stabilization. Second, fiscal discipline is critical in order to avoid
domestically financed deficits. Third a steady inflow of donor support or
other capital flows is also fundamental in maintaining a stable exchange
rate. Finally, interest rates must be managed flexibly with a view to
maintaining demand for local currency. In the long-term, the
diversification of the export base, increased investment to meet domestic
demand for consumption goods, reduction of external debt and maintenance
of a realistic exchange rate will be critical.
During this Bretton Woods System, member states were asked to state the
par values for their currencies in line with the Bretton Woods rules. They
intervened in the foreign exchange market in order to keep the market
exchange rate within one percent of the par value, by adding or reducing
their foreign Reserves (Hallwood, P., and MacDonald, R. (1989):
International Money: Theory, Evidence and Institutions; Basil Blackwell,
Oxford.
[2] Up to the late 1930s, countries were
operating under the ‘Gold Standard’ .This entailed the requirement
that domestic currencies be fully backed by gold reserves. This system
ended in the 1930s and between 1971 and 1973 countries were operating
under the Bretton Woods System in which domestic currencies had an
adjustable peg to the US dollar or other currency such as the pound
sterling or French franc.
[3] The United States was mandated to maintain
gold reserves which were to be exchanged for national currencies of member
states in the case of intervention to realign their currencies.
From 1974 the SDR was calculated in reference to a basket made up of
major international currencies with the US dollar having the largest
weight of over 40 percent in 1981. Other currencies composing the SDR in
1981 were Deutsche Mark (19%); Japanese Yen (13%); French franc (13%); and
the British Pound Sterling (13%).
Currencies in the basket and their weights were as follows: US dollar
(27 %); Pound Sterling (27 %); South Africa rand (18 %); German Deutsche
mark (7 %); Japanese yen (7 %); French franc (7 %); and the Netherlands
Guilder (7 %).
[6] c.i.f. /f.o.b. in full is cost, insurance
and freight and free on board, respectively, of cost of transportation.
[7] Foreign exchange Brokers were suspended
in November, 1994.
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Historical Background