Fear of Floating or Fear of Flying:
Exchange Rate Policy in the New Millenium
Eduardo Levy Yeyati
The World Bank & Universidad Torcuato Di Tella
December, 2006
1
Storyboard
 The basics: The debate post-Bretton Woods
 The tradeoff: Exchange rate regimes and the real
economy
 The evidence: Regimes in the 2000s
 The FIT (float + inflation targeting) paradigm:
natural evolution or fad?
 Fear of flying: building a case for a proactive
exchange rate policy
The basics
 The real view (‘70s)
 Trade (and welfare) gains vis à vis users of the peg
currency vs. loss of the exchange rate as a shock
absorber in the presence of nominal rigidities.
 Pro peg  Openness, propensity to trade, trade
concentration
 Pro float  Incidence of real shocks
The basics
 The political view (‘80s)
 Bands, “tablitas” & other soft species: Exchange rate
anchors as a “policy crutch” to compensate for the
lack of monetary credibility or political power
 Pro peg  high inflation, weak governments
The basics
 The financial view (‘90s)
 The trilemma: as the world integrates, countries have
to choose between monetary autonomy & a stable ER
 The bipolar view: Exchange rate policy in emerging
economies become more vulnerable to the limits
imposed by the trilemma: hard peg or float
 The unipolar view: Balance sheet effects due to
currency mismatches limit the scope for expansionary
devaluations  Hard pegs
The tradeoff
 Oversimplifying:
 Fix vs. flex  Enhanced monetary & fiscal discipline
(lower inflation) at the cost of greater sensitivity to real
shocks & output volatility…
 …except under FD (contractionary devaluations)
 Is this theoretical tradeoff validated by the evidence?
 Yes
The tradeoff
 Preliminary evaluation:
 Pegs contribute to lower inflation expectations…
 …at the cost of greater output volatility…
Regimes & output volatility
Dep. Var.: Change in growth rate
Flexible
Intermediate
Peg
t-1, j]
0.926***
(0.039)
0.974***
(0.043)
0.803***
(0.033)
Δtt_pos + Δtt*pos_1
0.059***
[7.99]
0.025
[0.92]
0.091***
[25.30]
Δtt_neg + Δtt_neg_1
0.078**
[5.99]
0.138***
[20.42]
0.174***
[64.79]
0.019
[0.24]
0.113***
[6.82]
0.083***
[7.16]
301
326
714
[g*j – g
neg - pos
Obs
Source: Edwards - LY (2005)
The tradeoff
 Preliminary evaluation:
 Pegs contribute to lower inflation expectations…
 …at the cost of greater output volatility…
 …and slower growth
Regimes & growth
Dep. Var.: growth
Period averages
(1974-1999)
Peg (%)
-1.89**
(0.77)
LYS(avg)
Obs.
R2
Source: LYS (2003)
5-year averages
(1976-2000)
-1.13**
(0.47)
-1.88***
(0.70)
73
73
299
0.522
0.523
0.210
The tradeoff
 Preliminary evaluation:





Pegs contribute to lower inflation expectations…
…at the cost of greater output volatility…
…and lower growth
Balance sheet effects
Subdued inflation fears  Volatility concerns
dominate  Float
 Under FD  Threshold floats
 The bipolar view after Argentina
Argentina: Fiscal (in)discipline
10%
8%
Lecop
Domestic market, voluntary debt
International market, voluntary debt
International financial institutions
Privatizations and other capital income
6%
4%
2%
0%
1991
1992
1993
1994
1995
Source: De la Torre-Schmukler-LY (2002)
1996
1997
1998
1999
2000
2001
Argentina: Monetary (in)discipline
200
4.00
Real cash in circulation (Left scale)
Real cash and quasi-monies in circulation (Left scale)
175
3.50
Nominal exchange rate (Right scale)
150
3.00
125
2.50
100
2.00
75
1.50
50
1.00
25
0.50
0
Jan-01
Mar-01 May-01
Jul-01
Source: De la Torre-Schmukler-LY (2002)
Sep-01
Nov-01
Jan-02
Mar-02 May-02
0.00
Jul-02
The bipolar view after Argentina
 Lack of external discipline by private markets 
Hard pegs do not lead to fiscal discipline
 Fiscal dominance  Hard pegs do not lead to
monetary discipline
 Is de jure dollarization hard enough?
Where do we stand?
 Pegs are passé  In most cases, inefficient
short-term substitute for credibility
 Hard pegs failed the test in Argentina
 Learning to live with BS effects  The (dynamic)
scope for countercyclical exchange rate policy
 The double D: Domestication and de-dollarization of
sovereign debt
 A unipolar view in reverse?
Exchange rate regimes in the 2000s: Classification
• Key criterion: ER variability relative to forex
intervention
• The intervention dimension is key to
characterized exchange rate policy (as opposed
to the evolution of exchange rates) and its
consequences
De facto regimes over the years: Distribution
90%
80%
78.23%
70%
61.29%
60.74%
60.63%
60%
50%
40%
30%
24.54%
19.35%
20%
19.35%
14.72%
16.25%
13.71%
8.06%
10%
0%
Fix
Int erm
1980
Source: LYS (2006)
1990
2000
Float
2004
23.13%
Emerging LATAM: A FIT paradigm?
60%
50.00%
50%
41.67%
41.67%
40%
33.33%
33.33%
33.33%
30%
25.00%
25.00%
20%
16.67%
10%
0%
Fix
Int erm
1991
Source: LYS (2006)
2000
Float
2004
The FIT paradigm
 Natural evolution or this year’s model?
 Less than a paradigm, more than a fad
 Negative experience with alternative options
 Inflation awareness  CB autonomy, fiscal restraint
 Decline in inflation –and dollar indexation– tilts the
balance towards more flexibility
 Inflation targets substitute for ER anchors
 Still far from the benign neglect
The comeback of exchange rate policy?
 Mercantilist interventions as a substitute for
protection
 Less specific than subsidies
 Less prone to mismanagement & corruption
 Fear of floating or fear of flying?
 Invertion of the ER anchor problem: sustaining an
undervalued currency
 Instead of amplified recessions due to price rigidities…
 …inflationary expansions fueled by positive real shocks.
 Does it work? How?
Fear of flying: A characterization
• Fear of floating’s underlying fears:
– Contractionary devaluations (due to BS effects) and
currency and debt crisis propensity
– Dollar pricing, pass-through and inflation
• Fear of flying: Leaning against the appreciation
wind
– Intervention to strenthen the demand for the foreign
currency, to avoid/mitigate appreciation pressures
Fear of flying over time (intermediates)
Source: LYS (2006)
Fear of flying over time (non-floats)
Source: LYS (2006)
…to avoid/mitigate appreciation pressures
Dependent variable: Log Real Exchange Rate
Variable
Annual average of int. Index (t)
Average
(t to t+2)
(t)
0.467***
0.504***
(0.207)
(0.216)
Annual average of int. Index (t-1)
-0.063
(0.224)
Annual average of int. Index (t-2)
0.163
(0.187)
Annual average of int. Index,
0.395**
(average over t to t+2)
(0.433)
R-squared
0.993
0.993
Additional controls: country and time FE, terms of trade, GDP of trade partners, net inflows.
Source: LYS (2006)
0.993
-1
-.5
0
e( ltcr | X )
.5
1
Real Exchange Rate Plot
-.2
-.1
0
e( ind_int_avg | X )
coef = .46681983, (robust) se = .20742027, t = 2.25
Source: LYS (2006)
.1
.2
Does it work?
DGDP
BK Trend
(t+1)
Annual average of int. Index (t)
BK Cycle
(avg, t+1 to t+3)
16.207***
(3.098)
∆(foreign_assets/M2) (t)
3.212***
(1.047)
∆(foreign_assets/M2) (t-3 to t)
9.394***
(2.521)
R-squared
0.287
0.2780
0.285
6.652***
5.192***
1.638**
(1.613)
(1.265)
(0.818)
0.405
0.598
0.111
∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2
Additional controls: country and time FE, terms of trade shocks, growth of pop., growth of trade partners, net inflows.
Source: LYS (2006)
Does it work?
Trend
Cycle
10
-5
0
5
e( prom_d_bkcicle_lgdp_un | X )
5
0
-5
-.2
-8.327e-17
.2
e( delta_ratio_res_m2_3ant | X )
coef = 6.6519224, (robust) se = 1.613162, t = 4.12
Source: LYS (2006)
.4
-10
-10
-10
-5
0
5
e( prom_d_bktrend_lgdp_un | X )
10
10
Growth
-.2
-8.327e-17
.2
e( delta_ratio_res_m2_3ant | X )
coef = 5.1922213, (robust) se = 1.2649193, t = 4.1
.4
-.2
-8.327e-17
.2
e( delta_ratio_res_m2_3ant | X )
coef = 1.6387782, (robust) se = .81826191, t = 2
.4
How?
∆ Import
Output
Volume
∆ Export
Output
Volume
(avg. t+1 to t+3)
∆ (foreign_assets/M2) (t-3 to t)
R-squared
17.917***
0.151**
14.780***
-0.012
(3.190)
(0.062)
(3.142)
(0.044)
0.9210
0.351
0.920
0.332
∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2.
Additional controls: country and time FE, ToT shocks, pop. growth., growth of trade partners, net inflows.
Source: LYS (2006)
How?
∆ Gross domestic
Savings
(t+1 to t+3)
Variable
∆(foreign_assets/M2) (t-3 to t)
R-squared
∆ Gross domestic
Investment
8.766***
10.208***
(2.691)
-2.156
0.825
0.744
∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2.
∆Log(ToT): Change of logarithm of terms of trade.
Source: LYS (2006)
0
-5
-15
-20
-10
-10
0
e( prom3_p_gkf | X )
10
5
10
20
Savings & investment
-.2
0
.2
e( delta_ratio_res_m2_3ant | X )
coef = 8.7655095, (robust) se = 2.6906957, t = 3.26
Source: LYS (2006)
.4
-.2
-8.327e-17
.2
e( delta_ratio_res_m2_3ant | X )
coef = 10.229713, (robust) se = 2.1584691, t = 4.74
.4
Taking stock
 Dedollarization and debt reduction reduce the
incidence of capital reversals
 Soft FIT paradigm replaces the ER as nominal
anchor
 Fear of flying is an increasingly popular
contender to drive domestic saving & investment
(but not so much exports)
 The exchange rate debate appears to have gone
full circle to the issues of the 1970s
Thank you
Fear of Floating or Fear of Flying:
Exchange Rate Policy in the New Millenium
Eduardo Levy Yeyati
The World Bank & Universidad Di Tella
December, 2006
33
Balance sheet effects & crisis propensity
Logit model - Dependent variable: Crisis dummy
Der
FL/FA
dollar
0.588***
-0.829
-0.610
-2.321
(0.158)
(0.706)
(1.128)
(1.552)
0.000***
0.003**
0.005**
0.007
(0.000)
(0.001)
(0.002)
(0.005)
0.745**
0.674*
0.676
0.411
(0.348)
(0.359)
(0.416)
(0.448)
0.072**
0.101**
0.146
(0.031)
(0.046)
(0.095)
1.310*
2.027*
3.196**
(0.695)
(1.049)
(1.335)
-3.555***
-3.493***
-2.455***
-2.912***
(0.292)
(0.300)
(0.529)
(0.496)
1104
1104
535
Yes
483
Yes
Yes
5.77**
5.27**
0.30
7.10***
4.86**
3.94*
7.11***
2.33
1.15
FL/FA * Der
dollar * Der
constant
Observations
Std. crisis controls
Institutions, SS & CC
Total effect (F-tests)
dollar
FL/FA
Der
Source: LY (2006)
Balance sheet effects & crisis propensity
Controlling for deposit dollarization ratios
100%
Low dollarization
High dollarization
60%
40%
20%
Exchange rate depreciation
5.
2
4.
8
4.
4
4.
1
3.
7
3.
3
3.
0
2.
6
2.
2
1.
9
1.
5
1.
1
0.
8
0.
4
0.
0
-0
.3
-0
.7
-1
.1
-1
.4
-1
.8
0%
-2
.1
Probability of a banking crisis
80%
De facto regimes over the years: Classification
 Exchange rate volatility (e): average of the absolute
value of monthly changes in the exchange rate
 Volatility of exchange rate changes (De ): standard
deviation of monthly changes in the exchange rate
 Volatility of reserves (R): average of the absolute value
of monthly changes in international reserves relative to
the monetary base of the previous month (both
denominated in US dollars)
De facto regimes over the years: Classification
Regime
e
De
R
Float
Low
Low
High
Intermediate
Med
Med
Med
Fix
High
Low
Low