But there are also opposing forces in the foreign exchange market. The basic balance deficit suggests a weaker krone. If developments in the world economy translate into lower prices for oil and other export goods, the value of the krone may also fall. If the krone depreciates, the key rate must be raised to a higher level than otherwise in order to keep inflation in check, unless slackened activity in the Norwegian economy results in lower inflation. Over time, however, the nominal exchange rate is not the main force. The main determinant of competitiveness in Norwegian business and industry and the purchasing power of the Norwegian krone is the real exchange rate. 12  BIS Review 37/2008  The real exchange rate can be measured in a number of ways, for example by consumer prices or labour costs in Norway relative to our trading partners measured in a common currency. This provides an indication of the relationship between the level of external and domestic prices, which in turn reflects developments in cost levels. In real terms, the krone has appreciated by about 10 per cent since the mid-1990s, while labour costs in a common currency have risen by close to 30 per cent more than among our trading partners. This may be partly ascribable to the cyclical expansion and the low level of household saving. But most likely the strong real krone reflects the substantial improvement in the terms of trade and productivity.
On the other hand, a flexible exchange rate regime can also work, provided that the policy package is correct and there is a well functioning foreign exchange and financial market. But it would be a mistake to think devaluation can substitute for fundamental policy adjustments to correct a structural external imbalance. Competitive devaluations are “beggar-thy-neighbour” policies that are self defeating. 31. Indeed, the adoption of more flexible exchange rate systems by some Asian economies has not meant they can avoid the adjustments that are currently being undertaken. With a fixed exchange rate under a very strong and disciplined regime in the form of a currency board system, Hong Kong focused precisely on our underlying productivity, maintaining strict financial and fiscal discipline, and also prudent banking supervision, in order to enhance the resilience of the linked exchange rate system, and minimize and manage the downside risks of overheating in the economy. 32. Let me also put the currency adjustments in their proper perspective. In the last few years, the currencies with the greatest adjustments and volatility have been the G-3 currencies, rather than the Asian currencies. The yen has depreciated by 50% against the US dollar from its peak in 1995. The deutschemark has likewise fallen by over 30%. In comparison, the Asian currencies have until recently remained relatively stable. The Hong Kong dollar has been the most stable of BIS Review 91/1997  -7-  Asian currencies, moving less than 1% against the US dollar.