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The Case for Hard Pegs

The Case for Hard Pegs. Guillermo A. Calvo. Research Department Inter-American Development Bank Guatemala, June 22, 2001. The Shifting Conventional Wisdom. Low Saving Rates (Tequila) Soft Pegs (Asia) Financial Sector (Russia). At present there is much greater consensus

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The Case for Hard Pegs

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  1. The Case for Hard Pegs Guillermo A. Calvo Research Department Inter-American Development BankGuatemala, June 22, 2001

  2. The Shifting Conventional Wisdom • Low Saving Rates (Tequila) • Soft Pegs (Asia) • Financial Sector (Russia) At present there is much greater consensus that financial vulnerabilities play a key role, especially a weak bankingsector.

  3. Key Stylized Facts • Large and volatile flows since 1989 • Initially, Portfolio Capital played key role, but it has subsided after Russia 1998 crisis. • Flows exhibit Sudden Stops even though there is no collapse of traditional fundamentals. • Official flows have become much smaller relative to total. • Central banks were part of the problem

  4. Real Capital Inflows to EM 2.5 Start of Financial Globalization--> 2.0 1.5 1.0 0.5 0.0 -0.5 72 74 76 78 80 82 84 86 88 90 92 94 96 98 Source: WEO, April 2000; deflated by US WPI.

  5. Portfolio Capital to Emerging Markets 150 100 Net Portfolio Inflows---> 50 0 -50 -100 Current Account---> -150 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 Source: WEO, IMF data bank, May 1999

  6. SUDDEN STOP

  7. Share of Official Capital to Emerging Markets 2.0 1.5 1.0 0.5 0.0 -0.5 76 78 80 82 84 86 88 90 92 94 96 98 Source: WEO data bank, IMF, May 1999.

  8. CENTRAL BANKS ARE NOT VERY HELPFUL AND MAY EXACERBATE THE SUDDEN-STOP EFFECTS

  9. Thailand’s Central Bank: a boxer who wouldn’t quit Thailand. Central Bank. Nominal 12-Month Variations 3.E+11 2.E+11 foreign assets---> 1.E+11 loans to financial non-bank institutions---> 0.E+00 -1.E+11 -2.E+11 90 91 92 93 94 95 96 97 Source: IFS 6

  10. Capital Flows: Summary • External factors play a key role: • US short-term interest rates • Creation of a market for Brady bonds. • contagion (Tequila, Asia, Russia, Turkey). • These factors are magnified into Sudden Stops due to credibility problems. • Central banks tend to magnify currency problems.

  11. Floating in Practice • Fear of Floating • Floating with a Life Jacket

  12. Floating with a Life Jacket (high international reserves) Reserves are used to stabilize the exchange rate through the following mechanisms: • forex intervention • threateningforex intervention • open market operations using international reserves as collateral.

  13. HARD PEGS VS. INFLATION TARGETING

  14. Hard Peg, HP, and Inflation Targeting, IT: Points in Common • HP fixes the relative price of the currency with respect to foreign exchange. • IT fixes the relative price of the currency with respect to a basket of goods. • Thus, under IT the exchange rate floats. • And under HP the price of the basket floats. query: who fixes, who floats? • Printing-press LOLR is ruled out in both HP and (credible) IT.

  15. HP vs. IT • HP is more transparent. • IT gives government more degrees of freedom in the short run. • However, under poor credibility freedom could be counterproductive. • Liability Dollarization and high pass-through coefficients lead to Fear of Floating. • Thus, IT may look much like HP without the benefit of low and stable interest rates.

  16. Inflation Targeting in EMs • It is another form of fixing. You fix to the price level (the price of dough)instead of fixing to the price of 1 unit of foreign exchange or tradable goods. • Hence, real exchange rate appreciation may occur. • Credibility problems may arise • in addition the central bank does not have dough reserves to intervene.

  17. Hard Peg: Key Criticisms • No Lender of Last Resort • Costly deflation

  18. Lender of last resort, LOLR: A Mirage • An effective LOLR should be able to borrow or run down reserves during crises. • Otherwise, the central bank must print money, provoking large price hikes and, possibly, hyperinflation. • Anticipating that the LOLR will pour money into banking problems, raises interest rates in tranquil periods (peso problem). • Thus, a printing-press LOLR couldworsen credibility problems.

  19. Deflation : A Serious Danger of Dollarization Irving Fisher Effect (Debt Deflation) • but the same problem arises with Liability Dollarization. • Solution: Develop financial system, foreign banks. Public sector price/wage inflexibility • Solution: Indexation to equivalent goods/services in private sector.

  20. The Case for Hard Pegs Guillermo A. Calvo Research Department Inter-American Development BankGuatemala, June 22, 2001

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