NAC Files, Lot 60 D 137

Memorandum by the NAC Staff Committee to the National Advisory Council

secret

NAC Doc. No. 1117

Subject: Appreciation of Currencies

Problem

The pattern of world trade has recently shifted as a consequence of the increased armament effort and rises in the prices of certain raw materials. There have also been abnormal movements of capital. Among the results have been improvements in the balance-of-payments positions of some countries, redistribution of monetary reserves, and [Page 1584] the widespread intensification of inflationary pressures. Suggestions for the appreciation of currencies have appeared in technical discussions and have been under consideration in several countries, as well as in the staff of the Economic Commission for Europe and other international bodies. It is desirable for the Council to give an expression of its views on this matter, particularly for the guidance of the United States Executive Director of the Fund, and of the diplomatic and ECA missions abroad.

Discussion

1. The Economic Effects of Appreciation

The immediate effect of an appreciation of a currency is to decrease the price of foreign currencies and of gold when expressed in the currency of the country revaluing. An appreciation, therefore, tends to stimulate imports and contract exports. It may be noted that the local currency value of gold and foreign exchange reserves on the books of the central bank decreases.

In general, the effect of an appreciation, therefore will be to increase a balance-of-payments deficit of a country which already has a deficit, or to decrease a surplus on current account of a country with an active trade balance. It is, however, difficult to predict either the change in the volume of exports in response to a reduction of price in local currency, or the effect on the price and volume of imports. The effect upon world prices of commodities will vary with the importance of the appreciating country as a supplier on the world markets and the effect of the appreciation on the quantity offered. In the case of many raw materials, particularly agricultural products, the total output may not be changed significantly in the short-run, although the decreased local currency price of exports may cause a larger portion of the total production to flow to the home market. On the other hand, if one country appreciates while others retain the existing exchange rates of their currencies, there would be a stimulus to imports, although if the imported goods are subject to controls or allocations abroad there need not be a corresponding increase in purchases. Where the volume of imports is limited by quantitative or exchange restrictions, appreciation would make the control more difficult.

If a large number of countries appreciated, there would be a tendency to divert their exports from the United States and other non-appreciating countries to each other, and to increase their imports from the United States and other non-appreciating countries. Thus, if most countries other than the United States appreciate their currencies,, they would tend to increase their net demands on goods from this; country at a time when goods are in increasingly short supply. Furthermore, on the assumption that there is a close relation between dollar payments and local currency supply prices, the diversion of their exports to local consumption or to each other would make it more difficult [Page 1585] for the United States to obtain needed supplies, or compel the United States to pay a higher dollar price for the goods which it needs.

2. Motives for Appreciation

It should, however, be noted that under current conditions, some or all of the effects of appreciation might differ markedly from those indicated in the conventional analysis of the foregoing paragraphs. In the case of some countries, the expectation of such unconventional results may provide a partial explanation of their interest in appreciation.

Under present world economic conditions, some countries may expect from appreciation either of two major advantages: (a) that it would tend to combat domestic inflation, or (b) that it would improve the country’s terms of trade and perhaps its balance of payments.

(a) Combating inflation

The anti-inflationary effects of currency appreciation have a considerable appeal in a period of wide-spread inflationary pressures. The local currency cost of imports is reduced, and this is expected to exercise a downward pressure on the price level. In a country where budgetary subsidies have been used to keep the cost of living down, appreciation would tend to reduce the need for such subsidies, and thus relieve pressure on the Government budget. Appreciation tends to reduce the local currency incomes of exporters, and thus to reduce the currency circulation. As a result, appreciation would tend to have an anti-inflationary effect.

A special form of inflationary pressure, speculative inward capital movements, may be present in some countries, and would tend to be checked by currency appreciation. As a result of world uncertainties, certain countries are recipients of heavy inward movements of capital seeking “safe haven”, even some countries which are still experiencing balance-of-payments difficulties on current account. Other devices are available for avoiding the inflationary impact of capital inflow, e.g., sterilization through budgetary surpluses, or the sale of Government bonds to the public, but the feasibility of such devices varies considerably from country to country in the light of political and economic factors. Appreciation may appear to be an easier method of discouraging capital inflow, and reducing the local currency cost, and thus the inflationary impact, of such flight capital as continues to come in.

(b) Improving terms of trade and balances of payments

In the present seller’s market, countries which export urgently needed goods in world short supply may anticipate better terms of trade with appreciation. While this consideration is likely to be of greater significance in the case of raw material producing countries, it may also be present in countries exporting important industrial goods. Such countries may consider that export prices can either be held in local currency terms or, at least, improved in terms of foreign exchange without commensurate decrease in the volume of exports. Vis-à-vis the United States, this expectation would be based upon the assumption that our price ceilings on imports will not be firm. On the import side, world shortages might be expected to minimize the increase in the volume of imports which would be conventionally expected to follow currency appreciation, and price controls in supplying [Page 1586] countries should prevent price increases. Thus while conventionally a currency appreciation would tend to worsen a country’s balance-of-payments, some countries may consider that in present circumstances appreciation could have the opposite effect. An incidental effect would be to permit central banks to pay for any accumulations of foreign exchange reserves at a lower cost in local currency. It should be noted that a balance-of-payments improvement as a result of appreciation would generally be incompatible with anti-inflationary objectives.

A complex of considerations might be present in this field. For example, a country which felt that some gains for its domestic economy would result from appreciation of its currency might wish to follow that course even at the expense of deterioration in its balance-of-payments if a prospect existed of thus increasing its own claim for extraordinary assistance or reducing the claims of others.

3. Effects of Appreciation on Other Countries

It should be noted that appreciation for anti-inflationary purposes would, if effective, intensify inflationary pressures in other countries, and appreciation which bettered the terms of trade of one country would ipso facto worsen the terms of trade of its trading partners.

Since advantages to particular countries may be offset by disadvantages to others, the United States position on the problem of appreciation should be formulated on the basis of the principles expressed in the Fund Agreement and other considerations underlying United States foreign financial policy.

4. Revaluation and the Fund Agreement *

Article IV, Sec. 5(a) of the Fund Agreement states: “A member shall not propose a change in the par value of its currency except to correct a fundamental disequilibrium.” The Fund may accept a proposed change if it is satisfied that the change is necessary to correct a fundamental disequilibrium, which may be reflected in an undue improvement or deterioration in the international financial position of the country concerned. While the Fund Agreement nowhere defines a fundamental disequilibrium it obviously meant to exclude a change in the balance-of-payments position of a country arising from temporary conditions either in its own economy or in the economies of other countries. Since the objectives of the Fund include the eventual adoption of non-discriminatory currency practices, including currency convertibility and elimination of multiple rates, it would appear that conditions of fundamental equilibrium and disequilibrium are reflected in the member’s ability to carry out its obligations under the Fund Agreement.

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The Fund Articles do not contemplate changes in par values to the advantage of one of its members, without regard to the welfare of the rest. If members could readily appreciate, or depreciate, their currencies in terms of gold whenever this seems expedient as a means of improving their internal price situation, their trading position, or their terms of trade, there would obviously be little meaning to the objective of exchange stability. Thus it is clear that currency appreciation is entirely incompatible with the Fund agreement if it is undertaken primarily for the purpose of taking maximum advantage of a temporary strong and inelastic demand for a country’s export products, without justification in terms of a fundamental disequilibrium. Such an action would be inadmissible under the code of international good monetary behavior which the Fund was set up to promote.

Furthermore, if a country maintains exchange control or quantitative import restrictions, it could scarcely argue that an appreciation (which would intensify the already excessive demand for imports) is necessary to correct a fundamental disequilibrium. Moreover, an improvement in a country’s balance-of-payments gives rise to obligations under GATT, and the Fund Agreement to relax, and eventually to eliminate import and exchange restrictions based on balance-of-payments grounds. The Fund could hardly concur in a currency appreciation which would tend to perpetuate the financial difficulties giving rise to the restrictions.

During May 1949, the Council expressed the opinion that “a country which finds it necessary to ration its dollar resources through the application of exchange restrictions on current transactions or quantitative import controls should be considered prima facie to be suffering from a fundamental disequilibrium.” This position has been consistently maintained by the United States in Fund discussions.

5. Other Considerations Underlying United States Foreign Financial Policy

The United States in the post-war period has provided approximately $30 billions in foreign aid, about two-thirds on a grant basis. This aid has been intended primarily to provide balance-of-payments assistance for reconstruction purposes. The aid in recent years has been increasingly on a grant basis.

In the period prior to September, 1949, the United States favored devaluation of the currencies of a number of leading countries as a measure to assist in redressing their dollar balances of payments. Since devaluation, and apparently at least partly as a result thereof, the balance-of-payments position of many of these countries has improved, and in some instances it has been possible to eliminate or reduce grant assistance. Nevertheless, a number of countries still require balance-of-payments assistance on a grant basis. There would [Page 1588] appear to be no justification for appreciation of the currency of a country which is still the recipient of grant aid from the United States for balance-of-payments purposes, since generally an appreciation would result in a deterioration in the country’s balance of payments.

6. Application of Analysis

The application of this analysis to a few typical cases is outlined in the following paragraphs.

(a) A country receiving balance-of-payments assistance, restricting imports, or maintaining exchange restrictions on current account transactions may experience a marked increase in foreign exchange reserves, which it regards as exerting inflationary pressure on its economy. As long as the country receives such assistance or maintains restrictions, its favorable balance-of-payments position cannot be regarded as indicative of a “fundamental disequilibrium”. For a country in this position, the increase in reserves could probably be brought to a stop by discontinuing foreign assistance or by abolishing the restrictions. These measures should have priority over currency appreciation.

(b) A country may experience a current account surplus (without receipt of extraordinary assistance or use of restrictions) at a time when it is temporarily unable to obtain desired imports from abroad. Such inability may be due either to non-availability of goods or to foreign export controls. In such a case, a judgment as to the existence of a “fundamental disequilibrium” is often difficult to make, since the magnitude of demand for the temporarily unavailable imports cannot readily be measured. In this situation, the most critical examination should be given any proposal for appreciation, and acquiescence should depend upon a strong showing that the improved balance-of-payments position is likely to survive the shortage period. Selective temporary measures, such as the suspension of import duties, or measures to sterilize foreign exchange inflow, might be more appropriate in a temporary situation, while trade is being diverted from its normal pattern.

(c) A country neither receiving assistance, nor maintaining restrictions on current transactions, may experience a sudden and striking inflow of reserves, resulting largely from capital movements. Such inflow, while usually indicating that the country’s financial position is regarded as reasonably secure, may be of a magnitude considerably beyond what could be anticipated on the basis of the country’s financial prospects alone. “Safe haven” objectives may be of particular importance. Here again, balance-of-payments developments reflecting such transitory factors are ordinarily not sufficient evidence of “fundamental disequilibrium”. Other measures to deal with the “hot money” inflow and its concomitant inflationary pressure should be fully explored in preference to appreciation, the acceptance of which should depend upon a clear showing of a solid improvement in the country’s earning position.

If a country has a well-developed banking system, it might, as an alternative to appreciation or to direct controls, be able to sterilize the additions to the money supply caused by an increase in monetary reserves, or it may adopt other anti-inflationary measures. Moreover, under the Fund Articles, while a country is expected to allow the greatest possible freedom in current account transactions, it is not [Page 1589] obligated to permit free capital movements. The Fund may even compel a member to impose restrictions on the outward flow of capital, so as to prevent a misuse of the Fund’s resources (Art. VI, Sec. 1(a)). The member is, moreover, permitted to impose “such controls as are necessary to regulate international capital movements”, provided that the member does not apply these controls in ways which will restrict current account transactions, or delay transfers. Thus, a country can, if it wishes, impose controls on the inward movement of capital, as well as its outward movement, though it may not be compelled by the Fund to control capital inflows.

(d) In the case of some industrial countries, inflationary pressures may arise, not from increased reserves, but from the impact of high prices for imported raw materials, and a rising wage-price spiral resulting from budgetary deficits generated by rearmament efforts or otherwise. In this case, it may be argued that currency appreciation, resulting in reduced local currency prices for imports would remove pressure for wage increases, while at the same time the foreign exchange earnings from exports might be increased. As indicated in the earlier discussion, currency appreciation is not appropriate either as an easy solution of domestic inflationary problems or as a means of changing the terms of trade in favor of one country or group of countries in the absence of evidence of fundamental disequilibrium which the appreciation would tend to correct. The remedy would again appear to be adoption of internal anti-inflationary measures, rather than exchange rate appreciation.

  1. While the Fund may not raise objections to changes of par values which do not exceed 10 percent of the initial par value agreed with the Fund (including the proposed change with any other changes which have previously been made), this 10 percent margin has been exhausted for most Fund members, principally by the exchange rate changes made in September 1949. [Footnote in the source text.]