IV. Exchange Rate Regimes
Lectures 19-20
Topics to be covered
I. Classifying countries by exchange rate regime
II. Advantages of fixed rates
III. Advantages of floating rates
IV. Which regime dominates?
● Tests
● Optimum Currency Areas
V. Additional factors for developing countries
•
•
•
Emigrants’ remittances
Financial development
Terms-of-trade shocks.
VI. Intermediate regimes & the corners hypothesis
Appendix: An alternative for commodity-exporting countries.
Professor Jeffrey Frankel
Continuum of exchange rate regimes:
From flexible to rigid
FLEXIBLE CORNER
1) Free float
2) Managed float
INTERMEDIATE REGIMES
3) Target zone/band
4) Basket peg
5) Crawling peg
6) Adjustable peg
FIXED CORNER
7) Currency board
9) Monetary union
8) Dollarization
Trends in distribution of EM exchange rate regimes
Distribution of Exchange Rate Regimes in Emerging Markets
3-category classification (IMF’s de jure), 1980-2011, percent of total
Ghosh, Ostry & Qureshi, 2015, IMF Economic Review, “Exchange Rate Management and Crisis Susceptibility: A Reassessment”
Trends in distribution of EM exchange rate regimes, continued
Finer classification (IMF’s de jure). 1980-2011, percent of total
}
(currency board or no
separate legal tender)
Ghosh, Ostry & Qureshi, (2015)
•
•
•
•
1973-1985 – Many abandoned fixed exchange rates
1986-94 – Exchange rate-based stabilization programs
1990s -- Corners Hypothesis: countries move to either hard peg or free float
Since 2001 -- The rise of the “managed float” category.
De jure regime  de facto
• Many countries that say they float, in fact
intervene heavily in the foreign exchange market. [1]
• Many countries that say they fix, in fact
devalue when trouble arises. [2]
• Many countries that say they target a basket of major
currencies in fact fiddle with the weights. [3]
[1] “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000).
[2] “The mirage of fixed exchange rates” -- Obstfeld & Rogoff (1995).
[3] Parameters kept secret -- Frankel, Schmukler & Servén (2000).
One statistical approach
to ascertaining de facto regimes:
Var (exchange rate) vs. Var (reserves).
•
Calvo & Reinhart (2002)
note that many countries that de jure say they float
in fact have a lower Var (Δe) relative to Var (ΔRes)
than many that say they fix!
•
Levy-Yeyati & Sturzenegger (2005)
classify all countries based on
variability of Δe vs. variability of ΔRes.
The de facto schemes do not agree
•
That de facto schemes to classify exchange
rate regimes differ from the IMF’s previous
de jure classification is by now well-known.
•
It is less well-known that the de facto
schemes also do not
agree with each other !
The de facto classification schemes tend to agree with
each other even less than they agree with the de jure scheme!
Percentage agreement of methodologies to code who pegs
De
Jure
Jay S.
LY-S
De
Jure
100%
Jay S.
86%
100%
LY-S
74%
80%
100%
R-R
81%
82%
73%
R-R
100%
De Jure: IMF. LY-S: Levy-Yeyati & Sturzenegger. R-R: Reinhart & Rogoff
Jay Shambaugh (2007)
II. Advantages of fixed rates
1) Encourage trade <= lower exchange risk.
• True, in theory, one can hedge risk. But costs of hedging:
missing markets, transactions costs, and risk premia.
• Empirical:
Exchange rate volatility ↑ => trade ↓ ?
Time-series evidence showed little effect. But more in:
- Cross-section evidence,
especially small & less developed countries.
- Currency unions: Rose (2000).
Professor Jeffrey Frankel
The Rose finding
• Rose (2000) -- the boost to bilateral trade from currency unions is:
– significant,
– ≈ FTAs, &
– larger (2- or 3-fold) than had been previously thought.
• Many others have advanced critiques. (Survey: Baldwin, 2006.)
– Re: sheer magnitude
• endogeneity,
• small countries,
• missing variables.
– Estimated magnitudes are often smaller,
• e.g., trade effect of euro has been at most 50% (e.g., Glick & Rose, 2016).
• but the finding that CU effect is as large as FTA effect
has withstood perturbations and replications well.
Advantages of fixed rates, cont.
2) Encourage investment
<= cut currency premium out of interest rates
3) Provide nominal anchor for monetary policy
• Barro-Gordon model of dynamically-consistent inflation-fighting.
• But which anchor? Exchange rate target vs. alternatives
4) Avoid competitive depreciation (“currency wars”)
5) Avoid speculative bubbles that afflict floating.
(versus: if variability is from fundamental real exchange rate shocks,
it will just pop up in prices instead of nominal exchange rates).
III. Advantages of floating rates
1. Monetary independence
2. Automatic adjustment to trade shocks
3. Retain seigniorage
4. Retain Lender of Last Resort ability
5. Avoiding crashes that hit pegged rates.
(This is an advantage especially if origin of speculative attacks
is multiple equilibria, not fundamentals.)
Professor Jeffrey Frankel
Advantage of monetary independence: Foreign interest
rates have a negative impact on GDP in pegged countries;
flexible exchange rates do insulate according to this study.
The effects of US (or other base country) interest rate R on real output growth:
Base R
1
Full sample
− 0.046
2
Nonpegs
0.046
3
Pegs
− 0.137**
4
Full sample
0.046
0.032
0.039
0.044
0.039
Base R × Peg
− 0.183**
0.055
Peg
0.014**
0.004
Constant
Observations
** Significant at 1%.
0.036**
0.030**
0.043**
0.030**
0.002
0.003
0.003
0.003
3831
2078
Robust standard errors clustered at country level
1753
3831
Sample: 1973-2002.
di Giovanni & Shambaugh (2008), "The impact of foreign interest rates on the economy: The role of the exchange rate regime," JIE.
di Giovanni & Shambaugh (2008), "The impact of foreign interest
rates on the economy: The role of the exchange rate regime," JIE.
IV. Which dominate: advantages of fixing
or advantages of floating?
Performance by category is inconclusive.
• To over-simplify findings of 3 studies:
– Ghosh, Gulde & Wolf:
hard pegs work best
– Sturzenegger & Levy-Yeyati: floats perform best
– Reinhart-Rogoff:
limited flexibility is best !
• Why the different answers?
– The de facto schemes do not correspond to each other.
– Conditioning factors (beyond rich vs. poor).
Professor Jeffrey Frankel
Which dominate: advantages of
fixing or advantages of floating?
Answer depends on circumstances, of course:
No one exchange rate regime is right
for all countries or all times.
• Traditional criteria for choosing - Optimum Currency Area.
Focus is on trade and stabilization of business cycle.
• 1990s criteria for choosing –
Focus is on financial markets and stabilization of speculation.
Optimum Currency Area Theory (OCA)
Broad definition: An optimum currency area is a region
that should have its own currency and own monetary policy.
This definition can be given more content:
An OCA can be defined as:
a region that is neither so small & open that it
would be better off pegging its currency to a neighbor,
nor so large & heterogenious that it would be better off
splitting into sub-regions with different currencies.
Professor Jeffrey Frankel
Optimum Currency Area criteria
for giving up currency independence:
• Small size and openness
– because then advantages of fixing are large.
• Symmetry of shocks
– because then giving up monetary independence is a small loss.
• Labor mobility
– because then it is possible to adjust to shocks even without
ability to expand money, cut interest rates or devalue.
• Fiscal transfers in a federal system
– because then consumption is cushioned in a downturn.
Professor Jeffrey Frankel
The endogeneity of the OCA criteria
• Bilateral trade responds positively to currency union
-- Rose (2000).
• A country pair’s cyclical correlation rises too.
• Implication: members of a monetary union
may meet OCA criteria better ex post than ex ante
-- Frankel & Rose (1996).
Professor Jeffrey Frankel
Popularity in 1990s of
institutionally-fixed corner
• currency boards
(e.g., Hong Kong, 1983- ; Lithuania, 1994-2015;
Argentina, 1991-2001; Bulgaria, 1997- ;
Estonia 1992-2011; Bosnia, 1998- ; …)
• dollarization
(e.g, Panama, El Salvador, Ecuador)
• monetary union
(e.g., EMU, 1999)
1990’s criteria for the firm-fix corner
suiting candidates for currency boards or union
Regarding credibility:
• a desperate need to import monetary stability, due to:
•
– history of hyperinflation,
– absence of credible public institutions,
– location in a dangerous neighborhood, or
– large exposure to nervous international investors
a desire for close integration with a particular neighbor or trading partner
Regarding other “initial conditions”:
• an already-high level of private dollarization
• high pass-through to import prices
• access to an adequate level of reserves.
V. Three additional considerations,
particularly relevant to developing countries
• (i) Emigrants’ remittances
• (ii) Level of financial development
• (iii) Supply shocks and
external terms of trade shocks
(i) Cyclically-stabilizing emigrants’ remittances.
• If country S has sent immigrants to country H,
their remittances are correlated with the differential
in growth or employment in S versus H. (Frankel, 2011)
• This strengthens the case for S pegging to H.
• Why? It helps stabilize the current account
even when S has given up ability to devalue.
(ii) Level of financial development
•
Aghion, Bacchetta, Ranciere & Rogoff
(2005)
– Fixed rates are better for countries at low levels of financial
development: markets are thin.
– When financial markets develop,
exchange flexibility becomes more attractive.
• Estimated threshold: Private Credit/GDP > 40%.
• Husain, Mody & Rogoff
(2005)
For richer & more financially developed countries,
flexible rates work better
– in the sense of being more durable
– & delivering higher growth without inflation.
(iii) External Shocks
Old textbook wisdom regarding source of shocks:
– Fixed rates work best if shocks are mostly
internal demand shocks -- especially monetary;
– floating rates work best if shocks tend to be real
shocks -- especially external terms of trade.
For a country subject to big terms of trade shocks
the exchange rate should be able to accommodate them.
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excessively tight money & recession.
Should commodity exporters float?
• The long-time conventional wisdom that floating works
better than fixing, for countries exposed to volatility in
the prices of their export commodities, has been
confirmed in empirical studies, including:
–
–
–
–
Broda (2004),
Edwards & Levy-Yeyati (2005),
Rafiq (2011),
and Céspedes & Velasco (2012).
Céspedes & Velasco (2012)
How big is the output loss when a country suffers
a boom-bust in its commodity price?
Céspedes & Velasco, 2012, IMF Economic Review
“Macroeconomic Performance During Commodity Price Booms & Busts”
Constant term
not reported.
(t-statistics in
parentheses.)
** Statistically
significant
at 5% level.
Across 107 major commodity boom-bust cycles,
output loss is bigger the bigger is the commodity price
change and the smaller is exchange rate flexibility.29
VI. Intermediate
exchange rate regimes
and the corners hypothesis
Intermediate regimes
• target zone (band)
•Krugman-ERM type (with nominal anchor)
•Bergsten-Williamson type (FEER mid-point adjusted automatically)
• basket peg
(weights can be either transparent or secret)
• crawling peg
• pre-announced (e.g., tablita)
• indexed (to fix real exchange rate)
• adjustable peg
(escape clause, e.g., contingent
on terms of trade or reserve loss)
The Corners Hypothesis
• The hypothesis: “Countries are, or should be,
abandoning intermediate regimes like target zones
and moving to either one corner or the other: rigid peg or free float.
Origins:
• 1992-93 ERM crises -- Eichengreen (1994)
• Late-90’s crises in emerging markets – Fischer (2001).
But the pendulum swung back,
• from a sample 61% of IMF staff in 2002, to 0% in 2010.
• Many developing countries follow intermediate exchange rate regimes.
Systematic managed float:
Turkey’s central bank buys lira when it depreciates,
and sells when it is appreciates.
Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013,
“How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14, Fig. 3.3
In Latin America, renewed inflows in 2010
were reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
Source: GS Global ECS Research
In Asia, Korea & Singapore in 2010 took renewed inflows
mostly in the form of reserves,
while India & Malaysia took them mostly
in the form of currency appreciation.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
Source: Goldman Sachs Global ECS Research
Data from Haver Analytics and Bloomberg
Appendix
IT versus alternative anchors
to take into account
commodity product prices
For a country that floats, by definition the exchange rate
is not to be the nominal anchor for monetary policy.
Then what is?
• Is full discretion an option?
– The Fed & some other major central banks, for now,
have given up on attempts to communicate intentions
in terms of a single variable,
• even via forward guidance, let alone an explicit target (like IT).
• But the presumption is still in favor
of transparency and clear communication.
• Many still feel the need to announce a simple target.
– Most developing countries, in particular,
need the reinforcement to credibility.
Monetary policy-makers in developing countries may
have more need for credibility.
a) due to high-inflation histories,
b) less-credible institutions, or
c) political pressure to monetize big budget deficits.
A. Fraga, I. Goldfajn & A. Minella (2003),
“Inflation Targeting in Emerging Market Economies.”
But it does not add to credibility to announce a target
which the central bank is likely to miss subsequently.
Solution for commodity exporters?
Fashions in international currency policy
• 1980-82: Monetarism (target the money supply)
• 1984-1997: Fixed exchange rates
(incl. currency boards)
• 1993-2001: The corners hypothesis
• 1998-2008: Inflation targeting (+ currency float)
became the new conventional wisdom.
Professor Jeffrey Frankel
6 proposed nominal targets and the Achilles heel of each:
Monetarist rule
Inflation targeting
Nominal income
targeting
Gold standard
Commodity
standard
Fixed
exchange rate
Targeted
variable
Vulnerability
Example
M1
Velocity shocks
US 1982
CPI
Import price
shocks
Oil shocks of
1973-80, 2000-08
Measurement
problems
Less developed
countries
Vagaries of world
gold market
Shocks in
imported
commodity
Appreciation of $
1849 boom;
1873-96 bust
Nominal
GDP
Price
of gold
Price of agric.
& mineral
basket
$
(or €)
(or € )
Oil shocks of
1973-80, 2000-08
1995-2001
Professor Jeffrey Frankel
Inflation Targeting
has been the reigning orthodoxy.
• Flexible inflation targeting ≡
“Have a LR target for inflation, and be transparent.”
Who could disagree?
• But define IT as setting yearly CPI targets.
• Then some reexamination is warranted.
Professor Jeffrey Frankel
• The shocks of 2008-2012 showed
disadvantages to Inflation Targeting,
– analogously to how the EM crises of the 1994-2001
showed disadvantages of exchange rate targeting.
• One disadvantage of IT:
no response to asset price bubbles.
• Another disadvantage:
– It gives the wrong answer in case of trade shocks:
• E.g., it says to tighten money & appreciate
in response to a rise in oil import prices;
• It does not allow monetary tightening
& appreciation in response to a rise
in world prices of export commodities.
• That is backwards.
Professor Jeffrey Frankel
What choice of monetary anchor or target?
• Of the variables that are candidates for nominal target,
• the traditional ones prevent accommodation of terms of
trade shocks:
1. Not just exchange rate target,
2. but also M1 (traditional monetarism)
3. and the CPI (Inflation Targeting).
• But some novel candidates would facilitate accommodation
of trade shocks:
4. Target an index of product prices (PPT)
5. Target Nominal GDP (NGDPT)
6. Add the export commodity to a currency basket peg (CCB).
New proposal:
Target a Currency + Commodity Basket (CCB)
• Consider three commodity-exporters that, at times,
have pegged to a basket of major foreign currencies:
– Kuwaiti dinar (1975-2003, 2007-present), pegged to basket of $ + €,
– Chilean peso (1992-1999) pegged to $ + DM + ¥,
– Kazakh tenge (2013-2014) to $ + € + ₱.
• The proposal is to add the commodity to the basket.
– E.g., oil for Kuwait & Kazakhstan,
– copper for Chile.
CCB: Add the export commodity
to the currency basket
Target a Currency + Commodity Basket (CCB)
• This target would give the best of both worlds:
– Has the advantages of a nominal anchor
• Like a peg, it is precise and transparent on a daily basis,
– determined by observed daily price in London or ICE.
– while yet sustainable on a long-term basis:
• Like a float, the currency would automatically
strengthen (vs. the $) when the $ price of oil rises,
• and automatically fall when the price of oil falls.
Does floating give the same answer?
• True, commodity currencies tend to appreciate
when commodity markets are strong, & vice versa
– Australian, Canadian & NZ $ (e.g., Chen & Rogoff, 2003)
– South African rand (e.g., Frankel, 2007)
– Chilean peso and others
• But
– Some volatility under floating may be gratuitous.
– And floaters still need a nominal anchor.
Professor Jeffrey Frankel
The Rand, 1984-2006:
Fundamentals (real commodity prices,
real interest differential, country risk premium, & l.e.v.)
can explain the real appreciation of 2003-06 – Frankel (SAfrJEc, 2007).
200.000
180.000
160.000
140.000
120.000
100.000
80.000
60.000
40.000
Actual
vs
Fitted
vs.
20.000
FundamentalsProjected Values
Q
Q
2
19
8
1 4
19
Q 85
4
19
Q 85
3
19
Q 86
2
19
Q 87
1
19
Q 88
4
19
Q 88
3
19
Q 89
2
19
Q 90
1
19
Q 91
4
19
Q 91
3
19
Q 92
2
19
Q 93
1
19
Q 94
4
19
Q 94
3
19
Q 95
2
19
Q 96
1
19
Q 97
4
19
Q 97
3
19
Q 98
2
19
Q 99
1
20
Q 00
4
20
Q 00
3
20
Q 01
2
20
Q 02
1
20
Q 03
4
20
Q 03
3
20
Q 04
2
20
Q 05
1
20
06
0.000
RERICPIactual
RERICPIFitted
RERICPIProjected
Professor Jeffrey Frankel