Time to change the exchange-rate in Malawi?

Currency exchange-rates have not played a large part in development policy since the introduction of the Poverty Reduction Strategy Process. This is the case in Malawi, which has undergone major economic reform in the last two decades. But slow growth in Malawi means the exchange-rate is back on the agenda.

A country’s exchange-rate canfollow either a fixed or a flexible system. The fixed system –a ‘hard peg’- aimsto keep the value of its currency fixed in relation to another currency, forexample the US dollar. This is managed through buying or selling foreigncurrency to balance demand and supply of the country’s imports and exports. An articlefrom the University of Londonexamines the choice of exchange-rate for Malawi, a low-income country. It shows that the exchange-rate policy can have asignificant effect on Malawi’s economy and theachievement of its development goals.

During the 1980s, Malawi had a fixed exchange-rate. In January 1994, underpressure from the International Monetary Fund (IMF), Malawi abandoned its ‘hard peg’. It was hoped that this flexibility- or a ‘floating’ exchange rate - would help boost exports, improve the balanceof payments and reduce inflation. However, performance has been poor. By 2004foreign currency reserves needed to pay for imports could cover only for oneand a half months’ payment.

When the IMF is involved in influencing policy inlow-income countries, its advice has generally been to have a ‘floating’ exchangerate. For those countries that are heavily exposed to international markets butwhich also have a well regulated domestic financial sector, this may work well.But the IMF has followed this policy even in countries where it may not beappropriate.

The article reports that:

• Malawi has limited exposure to world markets and anundeveloped financial sector, and so a ‘hard peg’ might be the best choiceto bring the biggest benefits in terms of both lower inflation and highergrowth.
• Good financialmanagement is necessary for Malawi: otherwise a ‘hard peg’ can lead to the over-valuationof its currency and cover up poor government administration.
• Although theexchange-rate is important, it is not the key factor for either exports orimports: other non-price factors have a larger impact on the economy.

In any country, a fixed exchange-rate cannot leadto economic growth without good financialmanagement. Recent progress by the new government of Malawi towards a well regulated domestic financial sector isencouraging. If this can be sustained, the return to a fixed exchange-rate can work.

However, policymakers and the IMF will also have to payattention to a number of other factors:

• continued unsustainablegovernment spending will lead to higher domestic interest rates
• a fixed exchange-ratealso requires adequate reserves and donor support to pay for the buying andselling of foreign currency
• re-introducingthe debate on exchange-rate policy in other sub-Saharan African countries
• changing the IMF ‘floating’ exchange-rate policy for Malawi as it may require more time to assess how well thenew government can manage the financial sector.