Lecture 21: Exchange Rate Regimes

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Lecture 21 Exchange Rate Regimes
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• What are countries doing?
• Classification of exchange rate regimes
• De jure vs. De facto
• What should countries be doing?
• Advantages of fixed rates
• Advantages of floating rates
• How should the choice be made?
• Performance by category
• Traditional criteria for choosing OCA framework
• 1990s criteria to suit a country for
  institutionally fixed rate
• Financial development
• External shocks Commodity price volatility.
• Addenda Attempts to classify countries
  regimes, performance
• The corners hypothesis

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1. Classification of exchange rate
regimeContinuum 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 8) Dollarization
• 9) Monetary union

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Intermediate regimes

• target zone (band)
• Krugman-ERM type (with nominal anchor)
• Bergsten-Williamson type (FEER 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)

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2. De jure regime ? de facto as is by now
well-known

• 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.
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• 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).

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3. Advantages of fixed rates

• Encourage trade lt lower exchange risk.
• In theory, can hedge risk. But costs of
  hedging
• missing markets, transactions costs, and risk
  premia.
• Empirical Exchange rate volatility ? gt trade
  ? ?
• Time-series evidence showed little effect. But
  more in
• - Cross-section evidence,
• especially small less developed
  countries. - Borders, e.g., Canada-US
  McCallum-Helliwell (1995-98)
  Engel-Rogers (1996).
• - Currency unions Rose (2000).

Professor Jeffrey Frankel
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Advantages of fixed rates, cont.

• 2) Encourage investment
• lt cut currency premium out of interest rates
• 3) Provide nominal anchor for monetary policy
• By anchoring inflation expectations, achieve
  lower inflation for same Y.
• But which anchor? Exchange rate target vs.
  Alternatives
• 4) Avoid competitive depreciation
• 5) Avoid speculative bubbles that afflict
  floating.
• (If variability were all from fundamental real
  exchange rate risk, and no bubbles, then fixing
  the nominal exchange rate would mean it would
  just pop up in prices instead.)

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4. Advantages of floating rates

• Monetary independence
• Automatic adjustment to trade shocks
• Central bank retains seignorage
• Central bank retains Lender of Last Resort
  capability, for rescuing banks
• Avoiding crashes that hit pegged rates,
• particularly if origin of speculative attacks
  is multiple equilibria, not fundamentals.

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5. Which dominate advantages of fixing or
advantages of floating?Performance by category
is inconclusive.

• To over-simplify 3 important studies (see
  Addendum I)
• Ghosh, Gulde Wolf hard pegs work best
• Sturzenegger Levy-Yeyati floats are best
• Reinhart-Rogoff limited flexibility performs
  best
• Why the different answers?
• The de facto schemes do not correspond to each
  other.
• A countrys circumstances determine the
  appropriate regime.

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Which dominate advantages of fixing or
advantages of floating? Answer depends on
circumstances No one exchange rate regime is
rightfor 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.

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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 and open that it would
be better off pegging its currency to a neighbor,
nor so large that it would be better off
splitting into sub-regions with different
currencies
Professor Jeffrey Frankel
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Optimum Currency Area criteria for fixing
exchange rate

• 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
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New popularity in 1990s ofinstitutionally-fixed
corner

• currency boards
• (e.g., Hong Kong, 1983- Lithuania, 1994-
• Argentina, 1991-2001 Bulgaria, 1997-
• Estonia 1992- Bosnia, 1998- )
• dollarization
• (e.g, Panama, El Salvador, Ecuador
• or euro-ization Montenegro)
• monetary union
• (e.g., EMU, 1999)

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Currency boards

• Definition A currency board is a monetary
  institution that only issues currency that is
  fully backed by foreign assets. Its
  principal attributes include the following
• An exchange rate that is fixed not just by
  policy, but by law.
• A reserve requirement stipulating that each
  dollars work of domestic currency is backed by a
  dollars worth of foreign reserves.
• A self-correcting balance of payments mechanism,
  in which a payments deficit automatically
  contracts the money supply, resulting in a
  contraction of spending.

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1990s criteria for the firm-fix corner
suiting candidates for currency boards or union
(e.g., Calvo)
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
• the rule of law.

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Two additional considerations, particularly
relevant to developing countries

• (i) Level of financial development
• (ii) Supply shocks, especially
• External terms of trade shocks and
  the proposal for Product Price
  Targeting

PPT
Professor Jeffrey Frankel
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(i) Level of financial development Aghion,
Bacchetta, Ranciere Rogoff (2005)

• Fixed rates are better for countries at
  low levels of financial
  development because markets
  are thin.
• When financial markets develop, exchange
  flexibility becomes more attractive.

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(ii) External Shocks

• An old wisdom regarding the 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).
• One case of supply shocks natural disasters
• R.Ramcharan (2007) finds support.
• Most common case of real shocks trade

Professor Jeffrey Frankel
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Terms-of-trade variability returns

• Prices of crude oil and other agricultural
  mineral commodities hit record highs in 2008, and
  again in 2011.
• gt Favorable terms of trade shocks for some
  (oil producers, Africa, Chile, etc.)
• gt Unfavorable terms of trade shock for others
  (oil importers like Japan, Korea).
• Textbook theory says a country where trade shocks
  dominate should accommodate by floating.

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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
• 1998-2007 Inflation targeting ( currency
  float)
• became the new conventional wisdom.
• 2008-09 IT lost some of its attractiveness in
  the Global Financial Crisis, due to its neglect
  of asset prices.

IT
Professor Jeffrey Frankel
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Addendum ISchemes for de facto classification

• have been divided into two categories, by Tavlas,
  Dellas Stockman (2008),
• mixed de jure-de facto classifications, because
  the self-declared regimes are adjusted by the
  devisers for anomalies.
• Vs. pure de facto classifications
  becauseassignment of regimes is based solely on
  statistical algorithms.

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IMF classification

• Of 185 Fund members,
• Have given up own currencies
• Euro-zone
• CFA Franc Zone
• E.Caribbean CA
• dollarized
• Currency boards
• Intermediate regimes
• pegs to a single currency
• pegs to a composite
• crawling pegs
• horizontal bands
• crawling bands
• managed floats
• independent floaters

• (end-2004 de facto)
• 41
• 12 14
• 6
• 9
  
  7
• 104
• 33
• 8
• 6
• 5
• 1
• 51
• 35

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Adjusted de jure classification schemes

1. Ghosh, Gulde, Ostry Wolf (1995) identify
   peggers who in fact devalue often.
2. Bubula Otker-Robe (2002) adjust by consulting
   IMF economists.
3. Reinhart Rogoff (2003, 04) add category of
   free falling.

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De facto classification schemes

• Shambaugh (2004) variability of exchange rate.
• Levy-Yeyati Sturzenegger (2005) cluster
  analysis based on variability of ? exchange rates
  vs. variability of ? reserves
• Implicit basket weights method regress ?value
  of local currency against ? values of major
  currencies. Frankel Wei (1993, 2007),
  Bénassy-Quéré (1999), B-Q et al (2004).
• Close fit gt a peg.
• Coefficient of 1 on gt peg.
• Or other currencies gt basket peg.

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The de facto schemes do not agree

• That de facto schemes to classify exchange rate
  regimes differ from the IMFs 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 !

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Correlations Among Regime Classification Schemes

• Sample 47 countries. From Frankel, Experience
  of and Lessons from Exchange Rate Regimes in
  Emerging Economies, ADB, 2004. Table 3,
  prepared by Marina Halac Sergio Schmukler.

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Three studies of how well exchange rate regimes
perform give different answers.
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Addendum II The corners hypothesis

• The claim
• Countries can rigidly peg or freely float, but
  should abandon intermediate
  regimes like target zones.
• Origins
• 1992-93 ERM crises -- Eichengreen (1994)
• Late-1990s crises in emerging markets
• 1994 Mexico
• 1997 Thailand, Korea
• 1998 Russia Brazil
• 2001 Turkey

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The rise fall of the Corners Hypothesis

• It became fashionable in the late 1990s
• But
• Since Argentinas 2001 crisis forced it to
  abandon its convertibility plan, currency
  boards and the corners hypothesis have lost
  popularity.
• The intermediate regimes are alive and well.
• The dominant long-term trend is, rather, toward
  flexibility.

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What is the rationale for the corners hypothesis?

• The Impossible Trinity? (Fischer,
  2001)
• No Intermediate regimes are theoretically
  compatible with high capital mobility.
• Procrastination? Governments politically
  postpone exit.
• (Mexico 1994 Thailand 1997) gt bad outcomes.
  (Willett, 2006)
• Moral hazard of forex reserves? (Dooley)But
  high reserves, empirically, reduce speculative
  attacks.

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Possible rationales for the corners hypothesis,
cont.

• To discourage mismatch (unhedged liabilities,
  Hausmanns original sin), even if it reduces
  capital inflow? (Eichengreen)
• Perhaps floating can shift debt-denomination to
  local currency, producing the good equilibrium
  after all (no currency mis-match).
• Since 2003, it seems to have worked more
  emerging market recipients of large inflows this
  decade now have floating exchange rates and
  local-denominated debt.
• The exceptions, like Hungary, got into big
  trouble in 2008

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• Or perhaps the grass always looks greener
  in the corners of the pasture.

• The pendulum has swung back
• Especially after failure of Argentinas currency
  board (okay, convertibility plan) 2001
  collapse
• Surely an intermediate regime (BBC) is the right
  answer for China now.

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Bottom line on corners hypothesis

• Dont cling to overvalued pegs.
• But dont blame the exchange rate regime for
  symptoms of other problems.