At the outbreak of the crisis, the world’s exchange rate “system”—a messy construct of flexible, managed, and pegged regimes, including a few currency boards and a large currency union—was not reassuring. The dollar, the world’s reserve currency, belonged to the country at the epicenter of the crisis. The specter of the protectionism, competitive devaluations, and sovereign debt crises that wrecked the world economy during the Great Depression loomed, and the IMF, the system’s ostensible surveillor and lender of last resort, had become dysfunctional.

Yet, exchange rates have adjusted in a remarkably orderly way and, while month-to-month volatility increased in 2009, changes in real exchange rates since the crisis’ outbreak have been modest, with a few notable exceptions. This orderly adjustment appears to have contributed to and resulted from global policy’s successful response to the crisis. However, it is too soon to declare victory: the growth outlook is improving but is still uncertain and severe exchange rate tensions remain that require a policy response.  

The Big Picture

From Lehman’s collapse to this week, most exchange rates have followed a path largely determined by the United States’ status as a safe haven. The path has gone through three phases, defined by varying levels of nervousness in the market. Overall, currencies across 34 major countries have depreciated by an average of 7 percent against the dollar from August 2008 to date.

In the first phase, which lasted roughly from September 2008 to March 2009, most currencies depreciated against the dollar as investors sought a safe haven, and the dollar appreciated 13.6 percent in nominal effective terms. Effective exchange rates are a trade-weighted average of a country’s bilateral exchange rates with its main trading partners.

From March through November 2009, much of the depreciation against the dollar reversed as confidence returned. Over the same period, the dollar depreciated 11.7 percent in effective terms.

Most exchange rates have followed a path largely determined by the United States’ status as a safe haven.

Since November, countries in the Euro area have begun to see depreciation against the dollar resume amidst concerns about the euro, with spillovers into the rest of Europe, and the dollar has appreciated an estimated 3.2 percent. However, currencies in Asian countries, including India, Indonesia, South Korea, and Thailand, as well as in Israel and several Latin American countries, have actually appreciated further.

Globally-coordinated policy—including the IMF replenishments and large new swap arrangements among central banks—as well as emerging markets’ solid pre-crisis policies and balance sheets helped maintain this order, which in turn bolstered confidence as vulnerable countries used exchange rate depreciation as a stabilizer early in the crisis.

However, there were three main exceptions to this pattern. First, countries pegged to the dollar, including China, Saudi Arabia, Venezuela, and Hong Kong, maintained their pegs with the aid of strong external balance sheets and large current account surpluses, helping other countries adjust during the worst of the crisis. Their effective exchange rates followed a path close to the dollar despite large differences in geographic trade weights. Second, the yen appreciated and remained high as Japan lost its monopoly of the carry trade (discussed further below). Third, chronically weak currencies in countries like Argentina and Pakistan depreciated but then stayed low.

Though most exchange rates are today near their pre-crisis levels in effective terms, their volatility, defined as the standard deviation of monthly exchange rates in a given year, increased in 2009. Volatility was greater than the 2000–2008 average in 24 out of 33 large economies, including the United States, Japan, China, and the UK. The sharpest increases in volatility reflected commodity prices, with commodity exporters like Australia, Canada, Colombia, and South Africa seeing a particularly steep rise. Several formerly planned economies—Russia, Poland, the Czech Republic, and Hungary—also saw more exchange rate volatility than other countries, reflecting the depth of the crisis there. Remarkably, the euro saw less volatility in effective terms in 2009 than it did in previous years.

Competitive Devaluations Avoided

Crucially, competitiveness, measured by real effective exchange rates, has held stable, with some exceptions. Real effective exchange rates are effective exchange rates adjusted for relative inflation. Across 24 countries for which comparable data is available, real effective exchange rates changed by an average of only 1.3 percent from August 2008 to February 2010.1 Shifts of more than 5 percent occurred in only 8 of the 24 countries over that period. Five of these countries are in Europe.

The UK, which enjoys exchange rate flexibility as a non Euro member, saw the sterling depreciate by 12 percent in real effective terms, reflecting the depth of the UK’s financial crisis. This especially hurt competitiveness in Ireland, a large UK trading partner and a Euro member. Ireland’s GDP contracted 7.5 percent in 2009, more than that of any other Euro area country. At the same time, the UK may also have softened the demand blow to others by allowing its fiscal deficit to rise by much more than the EU average. Sweden, also a non Euro member, saw its krona depreciate by 12 percent over the period.

Evidence suggests that Euro area members did not do quite as badly as many think.

Among the newly-acceded countries, Poland—one of the few countries to grow last year—saw the zloty depreciate by 17.8 percent. The Czech Republic and Hungary saw 11–12 percent depreciations, as Eastern Europe was hit hardest by the crisis.  

Japan, long the sole zero-interest economy, and the main source of funding for the carry trade, saw its currency rise more than 20 percent in both nominal and effective terms, on the back of a strong balance of payments position and despite massive and rising public debts, as other countries lowered their policy interest rates.


The exchange rate system’s performance has been reassuring so far. Going forward, however, numerous tensions remain, and they will get worse if the economic recovery disappoints and policy does not adjust.

In Europe, the debt challenges now facing weak Euro area members have triggered a new bout of concerns about the zone’s viability, but evidence suggests that its members did not do quite as badly as many think. Dispersion of GDP growth rates in the Euro area in 2009 (measured by their standard deviation) was actually less than the average from 2000–2008. Growth held up better in the central and eastern European countries that are members of the Euro area than in those that are not. 

The recession in Ireland and Greece might have been shallower if they had been able to devalue like the UK, Sweden, and Poland. The point is moot, however: abandoning the Euro today is not a serious option as it would also bring with it a surge in the value and cost of servicing foreign liabilities and sharply higher yields on domestic debt, not to mention a devastation of business confidence. At this point, structural reform, fiscal consolidation, and wage containment—which would be made easier by recovery and help from neighbors—are surely preferable to the disruption, interest rate hikes, and possible bankruptcy that leaving the Euro area would entail.

In Eastern Europe, countries that are not Euro members but maintain pegged exchange rates have not fared well and now face a pressing choice: increase flexibility or join the European Monetary Union (EMU). Of the Eastern and Central European countries with open capital accounts, GDP in those with fixed exchange rates contracted an average of 9 percent in 2009, more than twice the average of those with floating rates (-4 percent), and is projected to contract again in 2010. Some of this difference is due to the particularly sharp contractions in countries hoping to join the Euro area, like Latvia and Estonia.

Japan has seen one of the sharpest recessions as well as the return of deflation, and the high yen makes the problems worse.

China played a crucial stabilizing role during the worst of the crisis. However, with its exports among the first to recover and the yuan having depreciated modestly (2.1 percent) in real effective terms since the crisis’ outbreak, the country’s exchange rate policy has come under attack. Though a yuan revaluation by itself would probably have little effect on current account balances, if China resumed its pre-crisis appreciation policy—which had seen the renminbi rise 21 percent in nominal terms from June 2005 to July 2008— some trading partners would benefit, protectionist pressures against China would diminish, incipient inflationary pressures would be mitigated, and the country could better rebalance its economy.

Japan has seen one of the sharpest recessions as well as the return of deflation, and the high yen makes the problems worse. The high real interest rate on its large public debt could trigger a debt spiral unless nominal growth is reestablished. Medium-term fiscal consolidation and structural reforms are an important part of the answer. But Japanese policy makers must also hope for a sustained global trade recovery, and the return to normal policy interest rates in other countries, which would help it regain some lost competitiveness.

Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program. Vera Eidelman is the managing editor of Carnegie’s International Economic Bulletin.

1 Calculated using IMF data through November 2009 and approximated using real bilateral real exchange rates thereafter.