Fixation with fixed exchange rates harms developing countries

In recent months, a rash of crises has beset developing countries around the world.

• Nigeria has been running through its foreign exchange reserves and facing pressure to reduce expensive fuel subsidies.
• Egypt has faced a chronic shortage of foreign exchange and was forced to devalue its currency by sizeable amounts in 2023 and again in 2024.
• Bolivia is on the brink of a major crisis. A decline in the country’s natural gas exports, which has reduced the supply of dollars needed to pay for imports, has sparked a major balance of payments deficit and sharp fall in the country’s international reserves.
• Lebanon has been in crisis since 2019, the exchange rate has crashed, the government has defaulted on its debt and there is now a pervasive banking crisis.
• Sri Lanka has faced an economic crisis since 2019 and has seen its foreign exchange reserves evaporate, forcing it to default on its external and some domestic debt obligations and devalue its currency.

These economic pressures have led to social unrest and political instability. Nigeria has seen violence and social unrest as a result of the high cost of living. Egypt has become more repressive as public frustration grows. Bolivia is gripped by conflict between its current and past president that has led to street battles and an attempted coup. In Lebanon, the political system has collapsed. And just last weekend, Sri Lanka elected an anti-establishment neo-Marxist as its new president.

Although each of these countries has its own unique misfortunes, they also share an unfortunate commonality: the attempt to prop up a fixed exchange rate far too long—well after economic fundamentals have indicated a change in the exchange rate is necessary.

Unfortunately, this fixation on fixing the exchange rate while resisting market pressures for change is a recurring pattern. Officials desire to fix the exchange rate to reduce the cost of debt repayments and keep capital goods and consumer goods imports inexpensive. This may work for a time, especially if the exchange rate is fixed when a country’s economic environment is favorable.

Over time, however, as domestic prices rise or export demand falls, these fixed exchange rates can become increasingly unrealistic and detached from market reality. An overvalued currency prices the country’s exports out of the world market and makes imports cheap in comparison to domestic goods. This mispricing of foreign exchange leads to a drain of foreign exchange reserves and efforts to stanch the outflow—such as import restrictions and foreign exchange controls—only make matters worse. Instead of allowing a gradual depreciation of the currency to make the necessary adjustment, the country resists a devaluation for too long and wastes valuable foreign exchange in propping up the value of its currency. This makes the inevitable adjustment larger and more painful than necessary.

These factors have been at work in each of the cases mentioned above. In April, Bloomberg reported: “Nigeria is burning through foreign-exchange reserves at a rate not seen in four years, raising concerns that the central bank is depleting its dollar holdings to support the naira after pledging it would allow the currency to float more freely.” In the case of Bolivia, our colleague Alejandro Werner has pointed out: “After nearly 15 years of maintaining an official exchange rate of 6.90 bolivianos per dollar and no foreign exchange reserves to support it, Bolivia finds itself on the brink of a currency crisis that the authorities have yet to address.” In Lebanon, the central bank essentially ran a Ponzi scheme, relying on external inflows, sizable intervention and financial engineering to prevent the currency from falling in value.

One reason for these problems is the complacency that set in during the recent commodity boom. Officials enjoyed the bonanza of high prices for commodity exports and assumed it would continue. Bolivia’s boom in gas exports earlier during the 2000s is a case in point. Rather than smoothing spending in anticipation of a reversal of those prices or capital flows, the revenues were spent. This made the inevitable adjustments more painful. Other sources of current woes include budgetary imbalances and the desire to keep food and fuel prices low through the use of expensive subsidies.

But, in the end, the decision to maintain an overvalued exchange rate has almost always led to problems and is part of a recurring pattern. Egypt has gone through at least eight crises since it became a republic in 1952. As Agarwal and Mazarei point out: “The chronic problem has been a pattern of BOP (balance of payments) difficulties that have often required the abandonment of a fixed or highly stabilized exchange rate but been followed by a return to stable exchange rates once the crisis has subsided.”

Long ago, economists Sebastián Edwards and Peter Montiel observed that postponing a devaluation in the face of an adverse terms of trade shock or an unsustainable fiscal expansion simply made the eventual adjustment even larger and more painful. The ever-present temptation to avoid necessary adjustments to economic reality means that this sad lesson has yet to be learned in many countries around the world.

Fixing exchange rates or keeping currencies at artificially high levels has often been a precursor to severe economic crises. Flexible exchange rates allow countries a better way of adjusting to shocks and maintaining external competitiveness. By easing the balance-of-payments constraint on foreign exchange reserves, they also give countries an extra degree of monetary policy freedom, a major reason why many countries have adopted currency flexibility along with inflation targeting and successfully kept price increases in check. And in countries where there is a need to protect vulnerable populations from spikes in the prices of food, this is best done through well-targeted subsidies rather than a mispriced exchange rate. Flexible exchange rates may not be a magic bullet, but they are helpful in making necessary adjustments to changing economic conditions.