Topics to be covered • I. Classifying countries by exchange rate regime • II. Advantages of fixed rates • III. Advantages of floating rates • IV. Which regime dominates? • ● Tests● Optimum Currency Areas • V. Additional factors for developing countries • Emigrants’ remittances • Financial development • Terms-of-trade shocks; • the PEP & PPT proposals • VI. Intermediate regimes & the corners hypothesis • Appendices Professor Jeffrey Frankel
Continuum of exchange rate regimes: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
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.  • Many countries that say they fix, in fact devalue when trouble arises.  • Many countries that say they target a basket of major currencies in fact fiddle with the weights.   “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000).  “The mirage of fixed exchange rates” -- Obstfeld & Rogoff(1995).  Parameters kept secret -- Frankel, Schmukler & Servén(2000).
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) 41 12 14 6 97 104 33 8 6 5 1 51 35 IMF classification
Schemes for de facto classification • have themselves been divided into two classifications, viewed as: • “mixed de jure-de facto classifications, because the self-declared regimes are adjusted by the devisers for anomalies.” • Vs. “pure de facto classifications because…assignment of regimes is based solely on statistical algorithms….” -- Tavlas, Dellas & Stockman(2006).
Pure de facto classification schemes • Method to estimate degree of flexibility: • Calvo & Reinhart (2002) : var (exchange rate) vs. var (reserves). • Levy-Yeyati & Sturzenegger (2005): cluster analysis based on variability of Δ exchange rates vs. variability of Δ reserves. 2. Method to estimate implicit basket weights: Regress Δvalue of localcurrency against Δ values of majorcurrencies. Frankel & Wei (1993, 95, 2007), Bénassy-Quéré (1999), B-Q et al (2004). • Close fit => a peg. • Coefficient of 1 on $ => $ peg. Or on other currencies => basket peg. • Example of China, post 7/2005. 3. Synthesis method: F & Wei (2008), F & Xie (2010) .
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 !
Correlations Among Regime Classification Schemes Sample: 47 countries. From Frankel, ADB, 2004.Table 3, prepared by M. Halac & S.Schmukler. GGW =Ghosh, Gulde & Wolf. LY-S = Levy-Yeyati & Sturzenegger. R-R = Reinhart & Rogoff Professor Jeffrey Frankel
II. Advantages of fixed rates • Encourage trade <= lower exchange risk. • In theory, can hedge risk. But costs of hedging: • missing markets, transactions costs, and risk premia. • Empirical: Exchange rate volatility ↑ => 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
Most important finding of last decade Rose(2000) -- the boost to bilateral trade from currencyunions is: significant, ≈ FTAs, & larger (3-fold) than had been thought. Many others have advanced critiques of Rose research. Re: sheer magnitude Endogeneity, small countries, missingvariables &. Estimated magnitudes are often smaller, but the basic finding has withstood perturbations and replications remarkably well. ii/ Some developing countries seeking regional integration talk of following Europe’s lead, though plans merit skepticism. [ii] E.g., Rose & van Wincoop (2001); Tenreyro & Barro (2003). Survey: Baldwin (2006) Professor Jeffrey Frankel
Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 3) Provide nominal anchor for monetary policy • Barro-Gordon model of time-consistent inflation-fighting • But which anchor? Exchange rate target vs. Alternatives 4) Avoid competitive depreciation (“currency wars”) 5) Avoid speculative bubbles that afflict floating. (vs. if variability is fundamental real exchange rate risk, it will just pop up in prices instead of nominal exchange rates).
III. Advantages of floating rates • Monetary independence • Automatic adjustment to trade shocks • Retain seigniorage • Retain Lender of Last Resort ability • Avoiding crashes that hit pegged rates. (This is an advantage especially if origin of speculative attacks is multiple equilibria, not fundamentals.) Professor Jeffrey Frankel
IV. Which dominate: advantages of fixing or advantages of floating?Performance by category is inconclusive. To over-simplify findings of 3 important studies: Ghosh, Gulde & Wolf: hard pegs work best Sturzenegger & Levy-Yeyati: floats perform best Reinhart-Rogoff: limited flexibility is best ! Why the different answers? Conditioning factors (beyond, e.g., rich vs. poor). The de facto schemes do not correspond to each other. Professor Jeffrey Frankel
Which category experienced the most rapid growth? • Ghosh, Gulde & Wolf: currency boards • Levy-Yeyati &Sturzenegger: floating • Reinhart & Rogoff:limited flexibility
Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances, of course: 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.
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
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
Some evidence on currency unions • Endogeneity of OCA criteria: • Trade responds positively to currency regime • -- Rose (2000) • A pair’s cyclical correlation rises too(rather than falling, as under Eichengreen-Krugman hypothesis) • Implication: members of a monetary union may meet OCA criteria better ex post than ex ante. -- Frankel & Rose(1996) Professor Jeffrey Frankel
Popularity in 1990s ofinstitutionally-fixed corner • currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992-2011; Bosnia, 1998- ; …) • dollarization (e.g, Panama, El Salvador, Ecuador) • monetary union (e.g., EMU, 1999)
1990’s 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.
V. Three additional considerations, particularly relevant to developing countries (i) Emigrants’ remittances (ii) Level of financial development (iii) Supply shocks, especially: External terms of trade shocksand the proposal for Product Price Targeting PPT Professor Jeffrey Frankel
I would like to add another criterionto the traditional OCA list:Cyclically-stabilizing emigrants’ remittances. • If country S has sent immigrants to country H, are their remittances correlated with the differential in growth or employment in S versus H? • Apparently yes.(Frankel, “Are Bilateral Remittances Countercyclical?” 2011) • This strengthens the case for S pegging to H. • Why? It helps stabilize S’s current account even when S has given up ability to devalue.
(ii) Level of financial developmentAghion, Bacchetta, Ranciere & Rogoff (2005) Fixed rates are better for countries at low levels of financial development: because markets are thin => benefits of accommodating real shocks are outweighed by costs of financial shocks. When financial markets develop, exchange flexibility becomes more attractive. Estimated threshold: Private Credit/GDP > 40%. Professor Jeffrey Frankel
Level of financial development, cont.Husain, Mody & Rogoff (2005) For poor countries with low capital mobility, pegs work in the sense of being more durable & delivering low inflation For richer & more financially developed countries, flexible rates work better in the sense of being more durable & delivering higher growth without inflation Professor Jeffrey Frankel
(iii) 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
Terms-of-trade variability returns Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Latin America, 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. Confirmed empirically: Edwards & L.Yeyati (2005), “Flexible Exchange Rates as Shock Absorbers” --Among peggers, terms-of-trade shocks are amplified and long-run growth is reduced, as compared to flexible-rate countries. Similarly, Broda (2004) , Rafiq (2011) … Professor Jeffrey Frankel
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 1998-2008: Inflation targeting (+ currency float) became the new conventional wisdom Among academic economists among central bankers and at the IMF IT Professor Jeffrey Frankel
6 proposed nominal targets and the Achilles heel of each: IT Professor Jeffrey Frankel
Inflation Targeting has been the reigning orthodoxy. Flexible inflation targeting ≡“Have a LR target for inflation, and be transparent.” Who could disagree? But define IT as setting yearly CPI targets, to the exclusion of asset prices exchange rates export commodity prices. Some reexamination is warranted, in light of 2008-2012. IT Professor Jeffrey Frankel
The shocks of 2008-2012 showed disadvantages to Inflation Targeting, analogously to how the EM crises of the 1994-2001showed disadvantages of exchange rate targeting. One disadvantage of IT: no response to asset price bubbles. Another disadvantage: It gives the wrong answer in case of trade shocks: E.g., it says to tighten money & appreciate in response to a rise in oil import prices; It does not allow monetary tightening & appreciation in response to a rise in world prices of export commodities. That is backwards. IT Professor Jeffrey Frankel
Proposal for Product Price Targeting PPT • Intended for countries with volatile terms of trade, e.g., those specialized in commodities. • The authorities stabilize the currency in terms of an index of product prices, such as the GDP deflator, (a basket that gives weight to prices of its commodity exports), rather than to the CPI (which gives weight to imports). • The regime combines the best of both worlds: • The advantage of automatic accommodation to terms of trade shocks, together with • the advantages of a nominal anchor. Professor Jeffrey Frankel
Why is PPT better than CPI-targetingfor countries with volatile terms of trade? Better response to adverse terms of trade shocks: If the $ price of the export commodity goes up, PPT says to tighten monetary policy enough to appreciate currency. Right response. (E.g., Gulf currencies in 2007-08.) If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate currency. Wrong response. (E.g., oil-importers in 2007-08.) => CPI targeting gets it backwards. PPT Professor Jeffrey Frankel
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)
The Corners Hypothesis • The hypothesis: “Countries are, or should be, • abandoning intermediate regimes like target zones • and moving to either one corner or the other: rigid peg or free float. • Aliases: • “Hollowing out” • Bipolarity(Stan Fischer, 2001) • The Missing Middle(The Economist) • Hypothesis of the vanishing intermediate exchange rate regime • Origins: • 1992-93 ERM crises -- Eichengreen(1994) • Late-90’s crises in emerging markets • Other supporters included: Summers Treasury, CFR, IMF, Meltzer Commission, …
The pendulum swung back; the corners hypothesis ebbed: • especially after failure of Argentina’s currency board (okay, “convertibility plan”) • Most emerging markets absorbed the post-crisis inflows partly as currency appreciation, partly as reserve accumulation. • My annual survey: Do IMF staff think there was a swing in IMF policy in favor of the Corners Hypothesis (in the late 1990s)? • 2002: yes 61% (19/31). • 2004: yes 71% (32/45) . • 2006: “Still holds?” 47%(28/59). “Has reversed”: 51% . “Never serious”: 2% • 2007: 43% (16/34) “Has reversed”: 49% . “Never serious”: 8% 63% • 2008: 50% (16/34) “Has reversed”: 48% . “Never serious”: 2% 72% • 2010: 0% (0/24). 58% • 2011: 97%Do you personally believe in IT? 38% Is IT the new reigning orthodoxy at the Fund? “Yes” 100% IT
“Currency Wars” - Korea & Singapore in 2010 took inflows mostly in the form of reserves,while India & Malaysia took them mostly in the form of currency appreciation. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research
In Latin America, renewed inflows were reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating less-managed floating (“more appreciation-friendly”) Source: GS Global ECS Research
Exchange Market Pressure on Latin America continued in 2011Peru still accumulating reserves; Colombia is the free-est floater Goldman Sachs Global Economics, Global Viewpoint 11/09. 6/22/11; at https://360.gs.com
The flexibility parameter can be estimatedin terms of Exchange Market Pressure: • Define ΔEMP = Δ value of currency + xΔreserves. • ΔEMP represents shocks in currency demand. • Flexibility can be estimated as the propensity of the central bank to let shocks show up in the price of the currency (floating) ,vs. the quantity of the currency (fixed), or in between (intermediate exchange rate regime). x ≡ 1/MBaseor sometimes the inverse relative variance.
In Asia since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; HongKong & Singapore the least, followed by Malaysia&China. Goldman Sachs Global Economics Weekly 11/07Feb. 16, 2011
Distillation of technique to infer flexibility • When a shock raises international demand for the currency, does it show up as an appreciation, or as a rise in reserves? • EMP variable appears on the RHS of the equation. The % rise in the value of the currency appears on the left. • A coefficient of 0 on EMP signifies a fixed E(no changes in the value of the currency), • a coefficient of 1 signifies a freely floating rate (no changes in reserves) and • a coefficient somewhere in between indicates a correspondingly flexible/stable intermediate regime.
Appendix 1 On the RMB
Five reasons why China should move to a more flexible exchange rate regime, in its own interest • Overheating of economy • 2007: stock market bubble, bottlenecks, inflation 6%, price controls(Sept. 2007). • 2008-09 slowdown: loss of demand • Back by 2010. • Excessive reserves ($3 trillion as of mid-2011) • Though a useful shield against currency crises, China has enough reserves • Harder to sterilize the inflow over time. • Attaining internal and external balance. • To attain both, need 2 policy instruments. • In a large country like China, the expenditure-switching policyshould be the exchange rate. • Along with expenditure-increasing policies (2009). • Avoiding crisis: • Experience suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. • RMB undervalued, judged by Balassa-Samuelson criterion.
ED & TB>0 BB: External balance CA=0 Excgange rate E in RMB/$ China 2010 China 2002 ED & TD ES & TB>0 YY: Internal balance Y = Potential ES & TD China is now in the overheating + surplus quadrant of the Swan Diagram Spending A
How should changes in real exchange rate, when necessary, be achieved? • For a very small, open economy • advantages of keeping E fixed are large. • Adjustment may take place via prices instead • Example: Hong Kong • For a large economy like China, it makes more sense to adjust E than to adjust prices
What would new regime be? • No need for pure float. • China is an example of why the Corners Hypothesis is wrong • Band or target zone may be best • With what as anchor? • Advantage of dollar: simple and transparent • Advantage of basket: better diversification • Asia currently lacks a good anchor currency.
What about the currency reform announced in July 2005? • Movements of effective exchange rate have been small, vs. movement of $, € & ¥. • China did not really adopt the regime it said: basket peg (with cumulatable +/- .3% band) • De facto weight on $ still 100% in late 2005 • During 2007, weight had indeed shifted away from $; • Appreciation of € explained appreciation of RMB against $. • In mid-2008, RMB shifted back to a de facto $ peg again.
The RMB rose against the $ for 2 years, but returned to peg in mid-2008 $/RMB €/RMB €/$