Multiple Exchange Rates: Merits and Demerits | International Economics

In this article we will discuss about the merits and demerits of multiple exchange rates.

Immediately after the Second World War, almost 50 countries of the world were having a complex system of multiple exchange rates. The prominent among them were West Germany, Argentina and a number of Latin American countries. By 1950’s, the system was completely abandoned because of its complexities.

Under this system, different rates of exchange were fixed for imports and exports of different commodities. The object of fixing different rates of exchange was to obtain the maximum possible amount of foreign exchange by maximizing exports and reducing imports to the minimum extent. It was believed that this system was more effective in curing the problem of balance of payments deficit faced by a country.

Under the multiple exchange rates system, there was not only sufficient inducement to the exporters to enlarge their exports; there could be an additional incentive for them. They were allowed to sell a part of their foreign exchange earnings from exports at the unofficial higher rate of exchange. They could have the opportunity to import capital goods, raw material or technical know-how at some preferential and favourable rate of exchange.

Merits of Multiple Exchange Rates:

The main merits claimed for this system of exchange rates were as follows:

(i) More Effective:

The exchange depreciation and devaluation are not likely to bear desired results if the elasticities of demand for imports and exports are less than unity. The multiple exchange rates system permitted the exchange depreciation selectively for goods in case of which the elasticity co-efficient related to demand for imports and exports were more than unity and exchange appreciation remained enforced in case of other goods.

(ii) Off-Setting of BOP Disequilibrium:

The multiple exchange rates are the most appropriate in tackling the situation in which a country has a BOP deficit with a particular country or countries but an overall surplus. The lowering of exchange rate in case of only those commodities exported to and imported from those countries can adjust the BOP deficit without affecting the overall surplus. The fixed or flexible exchange rate is suited to adjust the overall BOP deficit or surplus. Neither of the two systems can have a differential effect.

(iii) Achievements of Desired Capital Flows:

If a country wants to achieve a higher capital inflow from one country and to prevent capital outflow to another country, the multiple exchange rates can serve the purpose with a high degree of success. A higher exchange rate applicable to the first and lower exchange rate applicable to the second can do the needful. In addition, the multiple exchange rates can be used for channelizing the foreign capital into more desirable lines of production.

(iv) Proper Planning of Imports:

A developing country wants to restrict the import of luxury goods and other consumer goods. At the same time it wants to enlarge the import of capital goods, intermediate goods, primary goods and technical know-how. A single uniform rate of exchange cannot facilitate such desired change in the composition of imports.

The multiple exchange rates can be very effective in this respect. Through proper planning of imports by selective application of rates of exchange on different categories of importable goods, a country can raise its development potential.

(v) Diversification of the Economy:

This system of exchange rates can permit the diversification of industries in a country through favourable rate of exchange. These can ensure protection to decaying industries from foreign competition. A series of new export goods industries can be developed. The processing industries and defense industries can be encouraged through more favourable rates of exchange. The industrial diversification through varied exchange rates can raise production, income, foreign exchange earnings and the level of domestic employment.

(vi) Additional Government Revenues:

As the multiple rates of exchange bring about expansion and diversification of industries, the government becomes able to realise additional revenues from excise duties and other domestic taxes.

(vii) Reduction in the Cost of Living:

The multiple exchange rates allow the import of necessary consumer goods at low prices. The competition from cheap foreign produced goods keeps the prices of domestically produced consumer goods also low. The import of cheap primary and intermediate goods keep the cost-push factors in check.

Thus the multiple exchange rates bring about a reduction in the cost of living and consequent improvement in the living standards of the people. This system of exchange rates can assist in price-stabilisation policies. The additional tax revenues obtained by the government can be harnessed in financing anti-inflationary policies.

(viii) Protection:

Through appropriate changes in exchange rate, the weak and sick industries in the home country can be protected from competition from the foreign produced goods, while at the same line, the growth of export industries can be promoted and necessary capital goods imports can be maintained through the favourable exchange rates.

(ix) Better Terms of Trade:

The multiple exchange rates can be used selectively to keep export prices at a higher level, while keeping import prices at a relatively lower level. In this way, a country practicing multiple exchange rates, can secure better or more favourable terms of trade.

Demerits of Multiple Exchange Rates:

This system of exchange rates is objected by critics on account of some of its demerits which are as below:

(i) Highly Complex and Cumbersome:

In this system of exchange rates, a country has a very complex and cumbersome structure. A large number of different rates of exchange are applicable to different categories of goods. It calls for large administrative machinery, bureaucratic red-tape and corruption. The authorities are required to have a highly complex system of trade and exchange controls to sustain it. The system can be likened to tight-rope walking when there are too many ropes.

The monetary authorities have to perform a very tough task of maintaining the stability of multitudes of officially fixed exchange rates. In view of its complexity and cumbersome character, the affected countries, GATT and IMF considered fiscal measures like taxes, subsidies and licenses as better than the multiple exchange rates.

(ii) Adverse Effect on Home Industries:

If the multiple exchange rates allow cheap imports from abroad, the domestic production is likely to be affected badly. It became evident in the cases like meat industry in Peru and wheat flour industry in Ecuador.

(iii) Discriminatory:

The multiple exchange rates are discriminatory in nature. If there is an over-all depreciation of currency, the adverse effect is widely spread over many commodities and many countries. On the opposite, the multiple exchange rates hit specific countries much harder. In view of its discriminatory effect, the international economic and political relations are likely to get worsened.

(iv) Black Marketing:

The multiple exchange rates lead to arbitrage. The foreign exchange is bought in the cheaper market and sold in the dearer market. Thus this exchange system promotes black marketing. The importers may import products at the more favourable rates and re-export the products at still more favourable exchange rates, applicable to different items of exports.

(v) Wasteful:

The system of multiple exchange rates is wasteful. It sometimes leads to large stock­piling of exportable goods in anticipation of more favourable reclassifications of some of them. The accumulation of inventory stocks signifies that investible resources have not been properly utilised.

(vi) Not a Sound Method for Financing Development:

It is claimed that the multiple exchange rates assist in mobilisation of large amounts of investible resources from the possible trade surplus. In addition, the additional tax revenues can also be utilised for financing the development programme in a less developed country.

In fact the multiple exchange system cannot serve as a sound method for financing development. It is not necessary that the multiple exchange system can generate sufficiently large export surplus to help finance a development programme.

As regards, the additional tax revenues, it may be pointed out that such revenue receipts are likely to be uncertain and unpredictable on account of unexpected changes in trade composition and the balance of payments position. The mobilisation of additional tax revenue, through heavily taxing exporters, violates the canons of equity and economy.

The development resources can be generated through the creation of large surplus only if this system of exchange rates brings about a substantial reduction in imports. There can be relatively greater reduction in the import of only those commodities, the demand for which is relatively more elastic.

In less developed countries, over the development process, the import of foodstuffs, raw materials, machinery and advanced technical know-how is inelastic. Therefore, the multiple exchange rates may not be effective in bringing about a desired reduction in imports. The capacity to export being also limited, the multiple exchange rates may fail to cause adequate enlargement of exports.

In fact, the LDCs remain confronted with persistent BOP deficits. From the above reasoning, it becomes clear that this system does not provide a sound way for financing development programme in the developing countries.

(vii) Absence of Requirements for Success:

The multiple exchange rates can achieve success in adjusting BOP disequilibrium, if certain requirements are fulfilled. Firstly, there should be complete knowledge about elasticities of demand for and supply of exports and imports. Secondly, the long-time must be given for making adjustments.

Thirdly, there must be the adequate availability of reserves of gold and other acceptable currencies for making adjustments. In actual reality, these requirements cannot be fully met. Therefore, the multiple exchange rates cannot achieve the desired results.

(viii) Less Effective than Quantitative Restrictions:

The quantitative restrictions such as import licenses, export licenses, exchange controls have proved to be relatively more effective in restraining imports than the multiple exchange rates. Even an unfavourable exchange rate applied in the case of a certain category of goods may not succeed in reducing import as in case of luxury goods. It is possible that the rich do not bother about the higher import prices of luxury goods and continue to import them as before.

In addition, the multiple exchange rates may be offset by monetary or fiscal policies pursued in either the home country or the foreign countries. It is for such reasons that economists had serious reservations about the effectiveness of multiple exchange rates relative to the quantitative controls.

To be more effective, the multiple exchange rates should be properly coordinated with the quantitative restraints. Each set of policies should reinforce the other in encouraging exports, restricting imports and mopping up of export receipts for furthering the development process.

The deficiencies of the multiple exchange rates are believed to outweigh their merits. Consequently, the world has developed stronger preference for managed float to a complicated and cumbersome system of multiple exchange rates which proved to be of a doubtful effectiveness.