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Lecture 21: Exchange Rate Regimes

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Lecture 21: Exchange Rate Regimes

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  1. Lecture 21: Exchange Rate Regimes ITF220 Prof.J.Frankel

  2. What exchange rate regimes do countries choose? • Classification of exchange rate regimes • What regimes should countries choose? • 2. 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 • Commodity price volatility and other trade/supply shocks:. • Appendices: I. De facto classification of countries’ regimes • II. The corners hypothesis ITF220 Prof.J.Frankel

  3. 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 ITF220 Prof.J.Frankel

  4. Distribution of EM exchange rate regimes The biggest rise is in the “managed float” category } Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011 (percent of total)World Economic Outlook, April 2014, Fig. 1.4.1, p.44, International Monetary Fund. ITF220 Prof.J.Frankel

  5. 3. Advantages of fixed rates • Encourage trade <= lower exchange risk. • In theory, can hedge risk. But costs of hedging: • transactions costs, missing markets, and risk premia. • Empirical: Exchange rate volatility ↑ => trade ↓ ? • Shows up 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). ITF220 Prof.J.Frankel

  6. Advantages of fixed rates, cont. 2) Encourage investment <= 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.) ITF220 Prof.J.Frankel

  7. 4. Advantages of floating rates 1) Monetary independence. 2) Automatic adjustment to trade shocks. 3) Central bank retains seignorage. 4) Central bank retains Lender of Last Resort capability, for rescuing banks. 5) Avoiding crashes that hit pegged rates, particularly if origin of speculative attacks is multiple equilibria, not fundamentals. ITF220 Prof.J.Frankel

  8. 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 country’s circumstances determine the appropriate regime. ITF220 Prof.J.Frankel

  9. 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. ITF220 Prof.J.Frankel

  10. Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency & 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 ITF220 Prof.J.Frankel Professor Jeffrey Frankel

  11. 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 ITF220 Prof.J.Frankel

  12. 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) ITF220 Prof.J.Frankel

  13. Currency boards • Definition: A currency board is a monetary institution that only issues currency 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 dollar’s work of domestic currency is backed by a dollar’s 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. ITF220 Prof.J.Frankel

  14. 1990’s criteria for the firm-fix corner suiting candidates for currencyboard 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 integration with a particular neighbor/ 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. ITF220 Prof.J.Frankel

  15. Two additional considerations, particularly relevant to developing countries (i) Level of financial development (ii) Supply shocks, especially: External terms of trade shocks Professor Jeffrey Frankel ITF220 Prof.J.Frankel

  16. (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. ITF220 Prof.J.Frankel

  17. (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 Most common case of real shocks: trade Professor Jeffrey Frankel ITF220 Prof.J.Frankel

  18. Terms-of-trade variability returns • Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008, and again in 2011. • => Favorable terms of trade shocks for some (oil producers, Africa, Chile, etc.); • => 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. ITF220 Prof.J.Frankel

  19. 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-: IT lost some of its attractiveness in the Global Financial Crisis, due to its neglect of asset prices. IT ITF220 Prof.J.Frankel

  20. Appendix I: 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-1990’s crises in emerging markets ITF220 Prof.J.Frankel

  21. 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) ITF220 Prof.J.Frankel

  22. The rise & fall of the Corners Hypothesis • It became fashionable in the late 1990s • But: • Since Argentina’s 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. ITF220 Prof.J.Frankel

  23. 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) => bad outcomes. (Willett, 2006) • Moral hazard of forex reserves?(Dooley)But high reserves, empirically, reduce speculative attacks. ITF220 Prof.J.Frankel

  24. Possible rationales for the corners hypothesis,cont. • To discourage mismatch (unhedged $ liabilities, Hausmann’s “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 ITF220 Prof.J.Frankel

  25. Or perhaps “the grass always looks greener” in the corners of the pasture. • The pendulum swung back: • Especially after failure of Argentina’s currency board (okay, “convertibility plan”) & 2001 collapse. • Surely an intermediate regime (BBC) is right for China now. ITF220 Prof.J.Frankel

  26. Appendix II:De facto classification of regimes 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). ITF220 Prof.J.Frankel

  27. Adjusted de jure classification schemes • Ghosh, Gulde, Ostry & Wolf (1995) identify “peggers” who in fact devalue often. • Reinhart & Rogoff (2003, 04) add category of “free falling”. De facto classification schemes • Shambaugh (2004): variability of exchange rate. • Levy-Yeyati & Sturzenegger (2005): cluster analysis based on variability of Δ exchange rates vs. variability of Δ reserves ITF220 Prof.J.Frankel

  28. 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 ! ITF220 Prof.J.Frankel

  29. 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. ITF220 Prof.J.Frankel

  30. Three studies of how well exchange rate regimes perform give different answers. ITF220 Prof.J.Frankel