Economy

Exchange Rates:The Targeting Debate

How to re-establish credibility and thus help resume growth fast is the challenge for emerging markets today. To achieve this, verifiable exchange rate regimes is the current prescription.

Is there an optimal exchange rate regime for emerging markets? The optimal exchange rate regime varies across countries and over time. History and the nature of the politics and institutions in the country matter, which makes it difficult to come up with a "one size-fits-all" policy recommendation. This was the main conclusion of a series of workshops organized by the World Bank during 2000 to promote debate on whether the choice of the exchange rate regime could help reduce the likelihood of output collapse associated with both a financial crisis and a successful defense of the exchange rate.

The need for credible institutions

The developing world is full of examples of costly attempts to bail out troubled banks, finance budget deficits and adjust the balance of payments by means of discretionary monetary policy. This practice has led to very high inflation episodes, massive capital flight and financial system troubles, leading to slow long-term growth and low policy credibility. This is not surprising. Much as governments would like to have monetary policy independence, if a country with an open capital account fixes the exchange rate, monetary policy will be determined by the economy's exchange rate commitment.

Whether or not countries claiming flexible exchange rates have fared better is still an open question. The truth of the matter is that, according to recent studies, few developing countries that now claim to have freely floating currencies really do. Governments often use interest rates or intervene in the foreign exchange market to achieve their implicit target exchange rate. The reason for this "fear of floating" is the threat of high inflation and/or financial collapse, as a result of depreciating exchange rates in face of a shock-particularly in the context of high foreign currency denominated debt. Fear of losing competitiveness as a result of an appreciated real exchange rate is also a rationale for not letting the exchange rate float freely.

Why worry about discretion in policymaking? It creates what in economics is called time-inconsistency problems. In a nutshell, if a government does not meet today's promises made yesterday, the public will not believe future announcements. If institutions are not credible, because of, say, the country's politics and history with inflation, schemes to restrain governments from using discretionary policies to some extent are needed to ensure investors locals and foreigners that the economic program is consistent and sustainable and that there is not going to be high inflation, nor perverse incentives for keeping real wages and prices from changing.

To achieve credibility fast, a time-inconsistent government needs fully verifiable policies. Three categories of verifiable exchange rate policies are being debated today: (a) intermediate regimes (publicly announced monitoring exchange rate bands); (b) extreme regimes such as inflation targeting; and (c) hard pegs (currency boards and full dollarization). The IMF has no clear choice of preferred exchange rate regime.

The case for intermediate regimes

In light of recent financial crises in economies with traditional adjustable pegs, e.g., East Asia's, proponents of intermediate regimes argue that emerging markets will have to live with more flexible exchange rate regimes than in the past to reduce the likelihood of financial crisis.

Williamson, for example, arguing that competitive exchange rates were one of the key foundations for the East Asian miracle, proposes a "publicly announced monitoring band, a range within which the authorities would commit not to intervene, but beyond which they would be free to intervene to push the rate back toward the band and without obligation to defend a particular rate." This strategy, Williamson argues, "would provide information on the long-term rate the authorities believe is consistent with long-term fundamentals, and hence where they should expect official action to limit misalignment. This should help stabilize expectations." Williamson also proposes ways to determine what exchange rate makes sense as well as the width of the band.

The case for inflation targeting

Several developing countries have adopted inflation targeting-Brazil, the Czech Republic, Israel, Poland and South Africa. The ultimate goal of inflation targeting is to reduce inflation uncertainty by making transparent the central bank's policy intention. Under this regime the central bank announces the inflation rate that its policies will aim at in the year ahead. This inflation commitment determines the exchange rate behavior.

But announcing a target inflation rate is not enough for a successful use of monetary independence. Institutional commitment (including legislative support for an independent central bank) to the target from the rest of the economy should also be there. This requires sound financial systems and fiscal stance. Successful inflation targeting also requires a mechanism that makes the central bank accountable for attaining its inflation objective and relatively low initial inflation rates. As Mishkin and Savastano discuss, in high inflation countries it will be difficult to identify the target, hence they will tend to be missed more often, which will jeopardize the central bank's credibility. In light of this, inflation targeting is likely to be a more effective strategy if it is introduced only after there has been some inflation reduction.

An important advantage of inflation targeting is that it allows the central bank to respond to shocks. It should be noted that in shock-prone economies with high foreign currency liabilities (e.g., dollar debts), inflation targeting will lead to volatile exchange rates, threatening the stability of firms and the financial sector. Also with high volatility in exchange rates it is very hard to develop long-term financial markets.

The case for hard pegs: currency board and full dollarization

Like inflation targeting, hard pegs are easily understood by the public Hard pegs consist of fixing the exchange rate to a hard currency, and holding enough reserves to back up the peg. In this category we find currency boards and the hard-peg extreme strategy, i.e., adopting another country's money such as the dollar. The case for hard pegs has been made strongly for emerging economies where the ability to buffer shocks is limited-economies with underdeveloped financial markets, widespread structural rigidities, weak political infrastructure-and where government and firm's ability to finance externally is highly volatile. These are economies where exchange rate movements could be very costly. Cases in point are economies with high dollar debts, as discussed.

In emerging economies, as argued by Calvo, "central banks are not very helpful and may exacerbate growth volatility due to financial vulnerability and credibility problems," as observed in emerging markets during the late 1990s. "An effective lender of last resort should be able to borrow or run down reserves during crises. Otherwise, the central bank must print money, provoking large price hikes and, possibly, hyperinflation. Anticipating that the lender of last resort will pour money to solve banking problems, raises real interest rates in tranquil periods… Thus, a printing press could worsen credibility problems." In other words, the lender of last resort capability of emerging market central banks de-facto is not there.

Currency boards. Countries with currency boards include Argentina, Estonia, Lithuania and Hong Kong. The regulatory framework of a currency board embodies a promise to convert domestic currency into a reserve currency, e.g., the US dollar, at a fixed exchange rate, and on demand. This means that at all times the monetary authorities must have enough foreign exchange reserves to honor its promise. It also implies that the government can finance its spending only by taxing or borrowing. In other words, a currency board "ties" the hands of the monetary authorities and prevents printing of money when it is not backed by reserves. Without a currency board Argentina would not have been able to survive the contagion from Mexico's 1994 financial crisis nor advance in its fiscal reform today.

Full dollarization. Under full dollarization, the central bank capability of printing money is removed, and the dollar is used for all types of monetary transactions. In Panama, for example, there is no central bank. Early this year, Ecuador, in the midst of economic and political turmoil, implemented full dollarization. Given the political structure of Ecuador at the time of the implementation of full dollarization, inflation targeting would not have worked. Ecuador's political infrastructure to get the fundamentals right was not there. More recently, El Salvador, announced that the dollar will be the legal unit of account for the financial system starting January 2001. Both the colon and the dollar will circulate in El Salvador. In the former case, the aim was to prevent weak fundamentals form becoming even weaker. In the latter case, the aim is faster growth in light of absence of currency risk. The experience of El Salvador, may prove useful for small income African countries where the challenge is to attain credibility to attract repatriated private capital.

Granted, full dollarization would not eliminate fiscal disarray, default risk, financial troubles due to deflation, and may be a costly exit strategy. Also wage and price inflexibility in the public sector may lead to unemployment, if the economy faces a shock. Because of this, proponents of full dollarization advise accompanying this regime with fiscal rules, such as New Zealand's law of fiscal responsibility to help achieving fiscal soundness. Likewise contingent sources of liquidity such as international banking (under the assumption that if faced with liquidity problems, headquarters will provide needed liquidity) and international credit lines, such as Argentina's repo facility, help buffering potential financial sector problems. Indexing public wages to private sector counterparts, as suggested by Calvo, could help solve the unemployment problem.

In countries where regional trade, and hence avoiding competitive devaluation is important, but a regional common currency is not politically feasible, for example in East Asia, as McKinnon explains, "establishing an efficient common monetary standard is , much more a matter of collective choice." Policy makers in a region with integrated trade should expend their political capital to ensure that countries in the region have similar commitments to stabilize their dollar exchange rates over the long term. Kawai also elaborates on a regional arrangement for the East Asian economies. Discussing regionally integrated economies is beyond the scope of this note.

To sum up, it is not fixed versus flex the exchange rate regime. It is whether fundamentals, including sound financial systems, are right. In particular, it is whether credible institutions set up to get fundamentals right are in place. How to sustain or re-establish credibility and thus help realize private sector investment plans and achieve stable financial markets is the challenge for emerging markets today. To achieve this, verifiable exchange rate regimes appear to be the order of the day.

Sara Calvo is senior economist of the Economic Policy Unit of the Poverty Reduction and Economic Management Network, The World Bank.

Courtesy: Development Outreach, Vol 3 No1, winter 2001 (The World Band Publication)

Arbitration: Still Unpopular Option.

Ram Kumar Kamat

In a marriage between two Persons, it might not be a good omen to think of the divorce on the very day of tying marital knot but in business it is the reverse. So, when Prakash Construction Pvt. Ltd. struck a deal with the Department of Roads to construct a bridge on Basaha river in Parsa district 13 years back, there was a provision in their contract to go for arbitration in case of dispute between them.

The company completed the construction of the bridge in the expected time frame some 11 years ago by bearing even the escalated price of the materials in the hope that increased cost will be covered by the employer as per the contract. Hence, after the completion of the project the company claimed Rs. 4.0 million more than the initial estimates, but the employer was ready to pay only Rs. 2.0 million. Since the legal ground for the claim was strong, the company decided to go for arbitration with a hope that it would settle the dispute soon.

It is eleven years since then, yet the company is not sure when the final decision will take place. A nice photograph of the same bridge adores the wall of Prakash Construction Pvt. Ltd. office. It should give a sense of achievement to Prakash Ratna Manadhar- Proprietor cum Managing Director of the company but the reality is that when even he stares at it, he feels a pang in his heart.

"Eleven years of court battle has cost me almost the amount I am to receive if I win the case, still we don't know when it will be finalized. I have now learnt a lesson to accept whatsoever amount my employer gives to me but not to go for arbitration and all this", says a weary Manadhar. "I am fed up with the legal procedures and feel allergic about lawyers. I went for the arbitration thinking that it will quickly settle the dispute. But it has no end and the case is still in the court", he laments.

According to Saman Manadhar, the Executive Director of the company, arbitration is a good option for the business dispute but since the policy makers are hostile to the philosophy of arbitration, it is discouraging for the companies to go for arbitration. The employers think that the arbitrators have taken bribe and so their decision is biased and this is why most of the cases go to the court only to linger for years, adds Saman. In Prakash Construction case, the arbitrators had fixed the amount at Rs. 3.0 million, midway between the two claims. As the employer did not agree to the arbitrators' decision, it went for an appeal. Thus, the case is now moving at a customary slow pace in the court.

However Prakash Construction is not the only business house to have such bad experience. In fact, most of the businesspersons fear to go for arbitration for a variety of reasons. Thus even after a decade of establishment of Nepal Council of Arbitration (NEPCA) there are less than 35 cases with the council.

According to experts it is impractical and sometimes impossible for the business community to get involved in a legal battle since it is much time consuming. So, when business disputes arise, they prefer arbitration and as the experience shows in foreign countries, in most of the cases arbitration finally settles the dispute. It is only in exceptional cases that appeal is made against the decision of arbitrators. But in Nepal it has been almost a usual phenomenon that the parties go to court even after the intermediation.

Though the business sector has expanded in our country, the parties however, hesitate to go for arbitration because they do not feel that arbitration is quick, says Iswor Raj Onta, chairperson of NEPCA- the only organization dealing with the vexed issues of intermediation. According to him there persists a psychology among the business persons, particularly in the construction business, that going for arbitration is equal to angering the employer and thus losing the chance of getting the next contract. This fear psychosis is hampering intermediation in business sector and this is something we must rid the sector of, Onta opines. Another reason why arbitration is not considered to be a reliable option is that the business community is still doubtful of the neutrality of an arbitrator, says Onta. According to him, though two disputing parties choose the arbitrators, such arbitrators are not supposed to take partisan view. But here the arbitrators seem to be acting just as a lawyer of the party he or she is appointed by. This ignorance prevails both in business and professional sector, Onta views.

On the other hand, lack of exposure of Nepali arbitrators to the big international cases, the international parties hardly choose Nepal as the place of holding arbitration, what to talk of trusting Nepali arbitrators. Perhaps a glaring example is the dispute between the parties of Singha Lager Beer. The disputing parties chose the two arbitrators but these two arbitrators who need to choose unanimously another arbitrator are still at loggerheads over the choice and hence the possibility of appointing international arbitrators is high.

Appointing international arbitrators is, however, too expensive for Nepali businesspersons, says Mahesh Raj Pant, General Manager of Chaudhary Group, one of the Nepali parties in Singha Lager Beer case. We have not had big cases of arbitration. Once this is frequently done in our soil, it will give some exposure to our experts and gradually international parties will have confidence in them for their ability and integrity, opines Onta.

Since the international parties have no faith in Nepali arbitrators, they always go for involving international arbitrators. As a result, when differences arise, Nepali parties, particularly the government agencies, bow to the claim of the foreign parties because of the fear that in case there is arbitration in foreign countries with foreign arbitrators, it would be too expensive. It has become time to tell the international parties that arbitration must take place in Nepal and if possible, even the arbitrators should be Nepali. But our bureaucracy doesn't seem to be mindful of this fact or else the Chinese contractor who was awarded contract in Marsyangdi I power project would not be in a position to bargain for International Chamber of Commerce (ICC) model of arbitration instead of UN model known as UNICITRAL.

Bharat Raj Upreti, a senior corporate lawyer, says, ICC model is more expensive in comparison to UN model. According to Onta, since the international parties are desperate to get contract in the beginning, they can be pressurized while writing the business contracts to relinquish such demand for international arbitrators and international venue. So is the view of another corporate lawyer Anil Sinha.

However, parties are still not convinced that arbitration is economical in terms of time and money compared to court procedure, Sinha says. Besides, lack of institutional development of intermediary institution and lack of highly technical professionals are other factors responsible for arbitration not being a reliable option. According to Sinha, as per New York convention on enforcement of foreign arbitral award-1958, any arbitration involving foreign parties that takes place in Nepal can easily be enforced in foreign countries and vice versa but this is something most of the Nepali parties are still unaware of. 

Private Sector & Running Taps

By Dr. Ramesh C Arya

The following lines have been extracted from the thousands of lines of the Water Resource Strategy Draft brought up for public discussion under the subtitle: Promote Private Sector Participation:

".. to develop at a faster pace, the role of private sector participation in the water sector will have to increase significantly, both in terms of financing and operations. In the hydropower sub-sector, legislation is already in place to promote private sector participation…In the water supply sub-sector, legislation will be put in place to enable private sector participation. Initially, in the water supply and irrigation sub-sector private sector participation will be promoted for operating the government schemes under contract. Later on, opportunities will be provided for private investments in expanded and improved water supply systems in urban areas,.. "

The Draft also established the functioning mechanism for cost recovery/ sharing for water supply and sanitation and stresses on enforcing

" 6.6.7.1 full cost recovery payment in the case of Urban Water Supply,

6.6.7.2 full cost recovery for O&M in the case of Urban Sewerage and Waste water Treatment, and

6.6.7.3 full cost recovery for O&M and part of Capital Cost in the case of Rural Water Supply."

On the water supply issue, the strategy has differentiated the urban and rural water supply users. The urbanites have to undergo "full cost recovery payment" while the latter with the full cost recovery for its Operations and Management but only part of the capital cost. Obviously, the latter group is the privileged group.

It has not been explained in clear terms whether the urban population is deemed relatively richer. Living in urban areas may be more out of the necessity and less because they are from the higher economic brackets. If the cost of providing the service is considered, it should be normally cheaper in the urban areas due to higher density of the user population. Lesser pipe lengths in urban areas could serve more number of clients and hence a higher rate of collection in the urban areas than in the rural ones where the population is sparsely located. But then the construction works in densely populated areas are costlier. According to an estimate of the Water Supply and Sanitation Collaborative Council, 35,000 rural people could be provided the basic services for the same cost of providing 1,000 urban residents with a centralised sewerage system.

Rather than discussing on the location of the user population and the differentiating the people of the same country on the basis of their settlements, the fundamental issue that has to be decided is how we view at the very service itself. Is drinking water a social commodity or is it an economic good? If it is an economic good for the urbanites, but not so for the rural mass, the latter should definitely be more advantaged population, receiving state subsidy which will require them to meet only part of the capital cost and meeting only the Operations and Maintenance cost.

It may further be examined by asking whether Drinking Water is a matter of Human Rights and a part of Basic Needs. And if it is so, to what extent should the state help meet the basic needs of the people by inviting the private sector for its management and seeking private sector investment in the urban (and not the rural) areas only? Isn't the State again differentiating the people in the matter of providing services by highlighting the focussed areas for private investment?

Recently, in an international conference on Water Resource, Human Rights and Governance, Peter Gleick of the Pacific Institute for Studies in Development, Environment and Security expressed the need to make more efficient use of the water we have. Many parts of the developed world have built the main infrastructure for water supply and energy. They have the luxury of having a choice of options. But, in places like Nepal, water supply is the basic infrastructure that is lacking. We need to address these issues first. We have to look at infrastructure from the ecological, hydrological and social points of view. The West does not need water at the basic level, but for waste disposal, for energy, for sanitation. In Nepal's context, it may be necessary to assess the water-requirement as basic needs. Will it be fair to expect full cost recovery from less than 20 percent of the population that has access to safe drinking water. When the quantity of water they are getting is well below the Basic Needs criteria.

About half of the national population of Nepal falls below the poverty line. In one of his studies Gleick has listed 82 countries where per capita domestic water use is under 100 litres per person per day (lpcd) for the year 2000. With Nepal at 12 lpcd, there are only 15 countries (most of them from Africa) at a lower consumption level. For Human Domestic Needs 20 litres per person per day is the recommended basic water requirement that includes 5 litres for drinking, 20 litres for sanitary services, 15 for bathing and 10 for food preparation. The expenditure for food preparation further excludes water required to grow food. A rough estimate of the water required to grow the daily food needs of an individual is 2700 litres.

Implicit in the phrase basic needs is the idea of minimum resource requirements for certain human and ecological functions and the allocation of sufficient water resources to meet those needs. A true minimum human need for water can only be defined as the amount of water needed to maintain human survival, approximately three to five litres of clean water per day. The US Agency for International Development, the World Bank and the World Health Organisation have recommended between 20 to 40 lpcd, each of which excludes water for cooking, bathing and basic cleaning.

It may be desirable that the Draft also considered the common public water supply system for the have-nots and the household water supply for the affording ones whether from the rural or the urban population. Kathmanduites have made use of Chandra Dhara as piped water supply when it was freely available at public places and nominally charged when supplied into the private households. The nominal rates may be based on the full cost recovery principle propagated in the Draft.

Let's hope, under the private sector initiatives, the Chandra Dharas

PUBLIC EXPENDITURE

Plugging the Loopholes

The high-level commission presents comprehensive, yet controversial,report to cut down the government expenditure. Will it be implemented?

By BHAGIRATH YOGI

The government must have a strong will to implement all that the Public Expenditure Review Commission (PERC) has advised it to do. In its report submitted to the government last week, the Commission has recommended, among others, to reduce the number of government employees by 22,000, scrap nearly 100 development projects and to freeze salary increment of civil servants for the next 10 years. The report has also recommended the government to make changes in the provisions of providing grant of Rs 500,000 annually to nearly 4,000 village development committees in the country. Nepal has little more than 100,000 employees in its civil service.

The Commission has also recommended introducing ‘old employees security system’ instead of the existing `pension.’ The Commission also drew the government’s attention toward the need for step-by-step privatization of all public enterprises except those providing economic services necessary from the point of view of social justice. The report also suggests providing full autonomy to the corporations in their work, making the board of directors and the executive chief of the corporation solely responsible for the final outcome of the corporation’s work, with the government limiting itself to the role of an investor only. The report has also recommended handing over of services like health, education, road construction etc. to local level bodies on a gradual basis.

Accepting the report, Finance Minister Dr. Ram Sharan Mahat said the report would be instrumental in managing government expenditures to be included in the next budget.

As expected, the part of the report related to the government employees drew flak from the concerned sector. "Instead of scrapping existing posts of the low level employees, the government should take effective measures to check corruption and leakages," said Bhavani P. Thani, chairman of Nepal Civil Servants Organization. Bhola Pokhrel, secretary of another civil servant’s association, said there was a need to link the employees’ salary with the inflation. "We would organize protest programs if the government decided to cut down the number of employees," he said.

The PERC has said there is a need to redefine the role of the government and cut down unnecessary expenditure from government coffers in a resource-scarce country like Nepal.

Amidst heavy criticism from the civil society and international donor community regarding the sheer waste of resources, the government had constituted a five-member Commission in September last year under the leadership of Nepali congress MP Binay Dhoj Chand, and asked it to submit a report for improving the government's expenditure management practices.

The Commission submitted its first interim report in November 2000.

The recommendations by the Commission range from identifying areas for the government’s involvement to amending national laws. It has also dwelt upon areas including reforms in administrative and financial management, foreign aided projects, controlling `berujus’ (unsettled accounts), reducing the practice of `advance money’ and strengthening internal control system. The Commission has also recommended ways to strengthen monitoring and evaluation of development programs.

 "The government will start implementing the recommendations while presenting the budget for the next fiscal year," said Finance Minister Dr. Ram Sharan Mahat. Whether he will be able to convince his colleagues in the cabinet to bring about drastic changes in their functioning, as envisaged by the PERC, remains to be seen.

Studies suggest that return on public investment in Nepal is much lower compared to similar spending in other countries in the region. Nepal is far more dependent on foreign aid than other South Asian countries to finance her development expenditure. In case of Nepal, aid financing of the fiscal deficit is about 6 percent of GDP, while the ratio is less than 2 percent of GDP for other South Asian countries. In Nepal, foreign aid finances on average a third of total public spending and over 60 percent of the development budget. In other South Asian countries this ratio is much lower—19 percent for Bangladesh, 6 percent for Pakistan and 8 percent for Sri Lanka.

The reform agenda adopted by the government and presented in the Nepal Development Forum meeting in Paris in April last year has envisaged the need for reforming the public expenditure management so as to improve the resource allocation, enhance the effectiveness of the projects, ensure financial discipline, promote economic health of the government and make the delivery of government services effective.

Major Recommendations Made by the PERC

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