Fear of Floating Guillermo A' Calvo Carmen M' Reinhart

1
Fear of FloatingGuillermo A. CalvoCarmen M.
Reinhart

• Presented By
• Rasha EL Kharbotly

2
First Glance

• Marching towards floating
• IMF
• Evidence against formal label

3
Thesis

• Paper analysis
• Exchange Rates
• Foreign exchange reserves
• Monetary aggregates
• Interest rates
• Commodity price
• Across the different exchange rate regimes to
  asses the correlation between the official
  label and actual practice.
• Monthly observations for 39 countries, from
  January 1970-November 1999. 154 exchange rate
  arrangements.

4
Construction

• I. Introduction
• II. Varieties of Fear of Floating
• 1. Monetary Policy and Lack of Credibility
• 2. Other reasons for Fear of Floating
• III. Fear of Floating The Evidence
• 1. Measuring Volatility Exchange Rates
• 2. Measuring Volatility International Reserve
• 3. Interest Rate Volatility, Lack of Credibility,
  and Procyclical Policies
• 4. Exchange Rates, Commodity Prices, and Fear of
  Floating
• Interest Rate and Exchange Rate Dynamics
• Concluding Remarks

5
Monetary Policy and Lack of Credibility Model

• Model
• m, e logs of money supply, and nominal exchange
  rate
• Et Mathematical expectations ?
  Interest-semi-elasticity parameter
• Exchange rate today is directly influenced by
  expectations due to lack of credibility.
• Present exchange rate is a weighted average of
  all future monetary aggregates.

6
Monetary Policy and Lack of Credibility Model

• Assume 1. Prefect Capital Mobility
• 2. International interest rate is zero
• Thus nominal interest rate is
• Thus nominal interest rate is also

7
Monetary Policy and Lack of Credibility Model

• Case 1 Permanent Increase in Present m
• Assuming stead state, according to (2) and (3)
  the exchange rate should devalue and interest
  rate would not be affected.
• Case 2 Permanent Increase in Future mAccording
  to (2) and (3) this would lead to an increase in
  exchange rate and interest rate.

8
Monetary Policy and Lack of Credibility Problem

• If the policy maker faced with a current
  depreciation does not increase the money supply,
  he will cause hardship in the real and financial
  sector.
• If the policy maker adjusts the money supply
  upward, this would lead to loss in credibility
  and future expectations could become more
  unruly and arbitrary.

9
Central-Bank-Controller

• A model created to help the policy maker control
  the money supply through CBC.
• Where
• interest-earning money
• There is a direct relationship between the CBC
  and interest rates.
• The data shows that EM exhibit a
  pro-interest-rate-volatility.
• Policy makers would chose to stabilize exchange
  over interest rate, since exchange rate provide a
  stronger nominal anchor for the economy.

10
More Reasons for Fear of Floating

• External debt and debt serves.
• Current account deficit.
• Terms of trade, commodities denomination. Limited
  hedging possibilities.
• Inflation problems, and the use of exchange rate
  to control the growth in m.

11
III. Fear of Floating The Evidence

• Pure Float is not very realistic
• The use of the G-3 , DM, to anchor the
  analysis. They are the closest to a pure float
  
• Four exchange regimes set by the IMF Peg,
  Limited Flexibility, Managed Floating, and
  freely-floating.
• Monthly frequency distribution of exchange rates,
  foreign exchange reserves, interest rates (real
  and nominal), monetary aggregates and specific
  commodity prices are analyzed within intervals
  and across regimes.

12
The Evidence

• Notation
• ? exchange rate ?R/R Foreign exchange reserves
  
• ?m/m Money base ?i Change in interest rate,
  it-it-1
• Xc An absolute value for a critical threshold (
  ?, ?R/R, ?m/m, ?i)
• For example x ?, where Xc 1
• Because of Fear of Floating ?R/R and ?m/m should
  exhibit the opposite relation
• As for ?i it is influenced by the credibility,
  exchange rate regime and the willingness of the
  policy maker to use to as a policy tool or not.

13
Measuring Volatility Exchange Rates

• Xc 1, Xc 2.5
• The conclusion from the tables are as follows
• P(?ltXCPeg)95.3gtP(?ltXCLimited
  flexibility)92.0gt P(?ltXCManaged
  Floating)87.5gtP(?ltXCFloat)79.3.
• Surprising conclusion is, EM kept a stable ?
  vis-à-vis the /DM, although they were suffering
  times of inflation and terms-of-trade shocks
• The difference across the regimes is very narrow.
  The difference is large when comparing Peg to
  Float, but it is not as significant for the
  remaining regimes.

14
Measuring Volatility International Reserves

• Original relationship
• There is evidence to prove contra this
  relationship as seen from the tables
• P(?R/R ltXcPeg) gt P(?R/RltXcFloat)
• Hidden foreign exchange transactions
• - Credit lines the case of European Exchange
  Rate Mechanism
• - Derivative transaction Thailands use of the
  futures market in 1997 to support its currency
• Relying on open market operations to decrease
  volatility in exchange rates.

15
Interest Rate Volatility, Lack of Credibility,
and Procyclical Policies

• The use of Policy to insure exchange rate
  stability, regardless of macroeconomic variables.
  
• The volatility in nominal and real interest rates
  is not due to policy fundamentals.
• The case of Mexico despite the move from Managed
  Float to Float, interest rates were still very
  stable. In the aftermath of The Russian crisis
  in 1998, interest rates were very high in order
  to limit exchange rate pressures, despite a
  slowing economy and a shock to terms-of-trade.
• Interest rates
• Most stable for Limited Flexibility Group
  European Countries.
• Least stable for Managed Floating EM countries.
  Lack of explicit money supply rules.

16
Exchange rates, commodity prices, and fear of
floating

• Concentration in primary good exports.
• Price of goods in domestic currency exhibit high
  volatility.
• Exchange rates are not adjusted to absorb the
  shock to commodity prices.
• Commodity prices in local currency are more
  volatile than exchange rates.
• Monthly fluctuations in excess of 5
• Floaters Prices is 38 versus 9 in exchange
  rates.
• Managed Floats Prices is 39 versus 4 in
  exchange rates
• Low correlation between exchange rates and
  commodity prices. Wrong sign, as apparent from
  the table.

17
Interest Rate and Exchange Rate Dynamics