Eduardo Levy Yeyati

1

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
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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

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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

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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

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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

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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

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The tradeoff

• Preliminary evaluation
• Pegs contribute to lower inflation expectations
• at the cost of greater output volatility

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Regimes output volatility
Source Edwards - LY (2005)
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The tradeoff

• Preliminary evaluation
• Pegs contribute to lower inflation expectations
• at the cost of greater output volatility
• and slower growth

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Regimes growth
Source LYS (2003)
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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

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Argentina Fiscal (in)discipline
Source De la Torre-Schmukler-LY (2002)
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Argentina Monetary (in)discipline
Source De la Torre-Schmukler-LY (2002)
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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?

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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?

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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

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De facto regimes over the years Distribution
Source LYS (2006)
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Emerging LATAM A FIT paradigm?
Source LYS (2006)
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The FIT paradigm

• Natural evolution or this years 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

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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?

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Fear of flying A characterization

• Fear of floatings 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

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Fear of flying over time (intermediates)
Source LYS (2006)
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Fear of flying over time (non-floats)
Source LYS (2006)
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to avoid/mitigate appreciation pressures

• Additional controls country and time FE, terms
  of trade, GDP of trade partners, net inflows.

Source LYS (2006)
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Real Exchange Rate Plot
Source LYS (2006)
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Does it work?

• ?(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)
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Does it work?

• Growth Trend Cycle

Source LYS (2006)
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How?

• ?(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)
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How?

• ?(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)
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Savings investment
Source LYS (2006)
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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

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• Thank you

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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
34
Balance sheet effects crisis propensity
Logit model - Dependent variable Crisis dummy
Source LY (2006)
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Balance sheet effects crisis propensity
Controlling for deposit dollarization ratios
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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 (??e )
  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)

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De facto regimes over the years Classification