Exchange Rate Regime for Emerging Markets

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Overview of the different exchange rate regimes and discussion of the optimal fit for different type of emerging markets

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Exchange Rate Regime for Emerging Markets

  1. 1. Exchange Rate Regimes for Emerging MarketsDiploma Paper Submitted to Professor Harris Dellas, Chair of Applied Macroeconomics, University of Bern Winter Semester 05/06 By Kilian Widmer 99-117-806
  2. 2. Exchange Rate Regimes for Emerging Markets Table of ContentsTable of ContentsFigures: ............................................................................................................ IIITables: ............................................................................................................. III1. Introduction.................................................................................................... 12. Emerging Markets and Exchange Rate Regimes ............................................ 33. Fixed versus Flexible ..................................................................................... 5 3.1 The Case for and against Fixed Exchange Rates............................................................7 3.2 The Case for and against Floating Exchange Rates........................................................9 3.2.1. Inflation Targeting ..............................................................................................10 3.3 Lender of Last Resort..................................................................................................12 3.4 Fiscal Policy ...............................................................................................................13 3.4.1. Fiscal Policy as the Problem................................................................................13 3.4.2. Fiscal Policy as an Instrument .............................................................................154. The Theory on the Choice of Exchange Rate Regime .................................. 16 4.1. Optimal Currency Area Criteria .................................................................................175. Emerging Market Issues ............................................................................... 21 5.1. Credibility..................................................................................................................22 5.2. Access to International Financial Markets ..................................................................24 5.3. Sudden Stops and Currency Crises .........................................................................25 5.4. Trade Issues ...............................................................................................................27 5.5 Effectiveness of Monetary Policy................................................................................28 5.5.1. Monetary Independence ......................................................................................28 5.5.2. Is Expansive Monetary Policy Contractionary? ...................................................31 5.5.3. Pass Through Issues ............................................................................................32 5.5.5. Wage Indexation .................................................................................................33 5.5.6. Unofficial Dollarization ......................................................................................34 5.5.7. Currency Mismatch.............................................................................................36 5.6. Fear of Floating .........................................................................................................416. Development of Institutions ......................................................................... 42 6.1. Financial Institutions..................................................................................................42 6.2. Monetary and Fiscal Institutions ................................................................................467. Conclusions.................................................................................................. 51 I
  3. 3. Exchange Rate Regimes for Emerging Markets Table of ContentsAnnex............................................................................................................... 53References:....................................................................................................... 60 II
  4. 4. Exchange Rate Regimes for Emerging Markets Figures and TablesFiguresFigure 1: Emerging Market Economies by Region..................................................................3Figure 2: Exchange Rate Regimes ..........................................................................................4Figure 3: Balance Sheets of Currency Boards and Central Banks............................................6Figure 4: Openness of Fixed Pegs.........................................................................................19Figure 5: Inflation in Mexico, Chile and Singapore...............................................................30Figure 6: Development of Debt Securities in Emerging Markets...........................................44Figure 7: Domestic Debt Securities in Advanced Countries and Emerging Markets………...44Figure 8: % of Nonperforming Loans in Emerging Markets..................................................45Figure 9: % of Nonperforming Loans in Advanced Countries and Emerging Markets...........45Figure 10: Inflation in Emerging Markets .............................................................................47Figure 11: Public Debt in Emerging Markets ........................................................................49Figure 12: Emerging Market Sovereign Credit Ratings .........................................................49Figure 13: Local and Foreign Currency Credit Ratings .........................................................49TablesTable 1: Foreign Exchange and Derivatives Markets in Emerging Markets...........................43Table 2: Inflation, Fiscal Balances, and Seigniorage in Emerging Markets............................48Table 3: Openness of Emerging Market Economies..............................................................53Table 4: Domestic Debt Securities in Emerging Markets ......................................................54Table 5: Domestic Debt Securities in Emerging Markets (in % of GDP)...............................55Table 6: Domestic Debt Securities in Advanced Countries in 2004.......................................56Table 7: Public Debt in Emerging Markets ...........................................................................57Table 8: Percentage of Nonperforming Loans in Emerging Markets .....................................58Table 9: Percentage of Nonperforming Loans in Advanced Countries...................................58Table 10: Emerging Market Sovereign Credit Ratings ..........................................................59Table 11: Fear of Floating (Calvo and Reinhart) ...................................................................60Table 12: Fear of Floating 2002-2005...................................................................................61 III
  5. 5. Exchange Rate Regimes for Emerging Markets Chapter 11. Introduction The choice of exchange rate regime is a topic that has been thoroughly discussed ineconomic literature. Reviewing the literature, I find that the debate has almost raised as manyquestions as it has delivered answers. The influence of particular exchange rate regimes on thereal economy essentially remains unclear, as empirical evidence is mixed and problems ofreverse causality arise. Likewise, there is no overall consensus on the relative importance ofspecific factors influencing the choice of exchange rate regime. However, one indisputableconclusion that has emerged is that the standard theory on the choice of exchange rate regimesfor industrialized economies does not apply well to emerging markets and developingcountries. Emerging markets are a very heterogeneous group of economies that differ widely in theireconomic features, especially Asian and Latin American economies. However, one fact allemerging market regions have in common is that they all faced currency and financial crisesin the past decade, indicating that exchange rate regimes in emerging markets are less stablethan in their industrial counterparts. These crises have shifted the focus of economists onfactors and characteristics that are specific to emerging markets and developing countries, orare of substantially less importance in advanced countries. Most of these factors are linked tothe lower credibility of monetary policies and institutions in emerging markets, making themmore vulnerable to exchange rate variability. Essentially, an exchange rate regime should set a framework that enables policymakers toreach their macroeconomic goals and create an environment that is conducive to economicgrowth. In the past both fixed and flexible regimes have not succeeded in providing thisframework, documented in the crises of fixed regimes and the high rates of inflation inflexible regimes. While exchange rate regimes have an effect in altering the characteristics ofan economy, it is basically a country’s characteristics that determine which exchange rateregime is best suited to the needs of the respective economy. As the characteristics of aneconomy change, so does its “optimal” regime (Frankel, 1999). The vast differences amongemerging markets do not allow a generalization of a best solution concerning the choice ofexchange rate regime. However, there are certain general developments among emergingmarkets that speak for an increased amount of exchange rate stability or an increased amountof flexibility. 1
  6. 6. Exchange Rate Regimes for Emerging Markets Chapter 1 While both fixed and flexible regimes have their virtues and drawbacks, there is no overallconsensus among economists on which is the better solution for emerging market economies.In recent years there has been a trend among emerging markets towards increased flexibility,and currently the majority of economies have floating regimes installed (Hakura, 2005).However, their actual exchange rate behaviour indicates that many countries are deliberatelylimiting swings in their exchange rate, thereby often resembling the behaviour of fixedregimes (Calvo and Reinhart, 2002). The focus of this paper is to give an overview of the advantages of fixed and flexibleexchange rate regimes, to document characteristics that are specific to emerging markets, andto show the implications of these characteristics on the choice of exchange rate regime and theactual behaviour of exchange rates. The paper is structured as follows: The second chapter gives an overview of the group ofemerging market economies and different exchange rate regimes. I discuss the basictheoretical advantages fixed and flexible exchange rate regimes entail in chapter 3, whilechapter 4 takes a look at the standard theory on the choice of exchange rate regime. The fifthchapter analyses specific factors that are prevalent in most emerging market economies andhow they influence the behaviour of exchange rates and monetary policy. The development ofinstitutions in emerging markets is the topic of the sixth chapter, while the concluding chaptertouches on the implications of my findings. 2
  7. 7. Exchange Rate Regimes for Emerging Markets Chapter 22. Emerging Markets and Exchange Rate Regimes Empirical researches in emerging markets analysing the factors that have an influence on thechoice of a specific exchange rate regime, and conversely the influence of certain exchangerate regimes on real macroeconomic variables, depend on the choice of exchange rate regimeclassification as well as the definition of emerging market economies. There are several different definitions of emerging market economies that differ slightlyfrom each other, mainly in the number of economies included, but essentially all definitionsare grouped around the same core of economies. I will be using the group of 25 emergingmarket economies (Figure 1) presented in Rogoff et al. (2003), which are identical to thegroup of economies in the Morgan Stanley Capital International (MSCI) index.Figure 1: Emerging Market Economies by RegionLatin AmericaArgentina Brazil Chile Colombia Mexico PeruVenezuelaAsiaChina India Indonesia Korea Malaysia PakistanPhilippines ThailandEurope, Middle East, and Africa (EMEA)Czech Republic Egypt Hungary Israel Jordan MoroccoPoland Russia South Africa Turkeysource: Rogoff et al. (2003) Regarding the classification of exchange rate regimes, there seems to be no consensusamong economists on a single, correct classification scheme. A problem that arises is that thebehaviour of exchange rates (de facto) often does not correspond with the announced regime(de jure) in place. While exchange rate classifications in the past were based on theannounced regime, recent classifications have focused on the actual behaviour of regimes1.Other principal differences among exchange rate classifications arise due to the differentnumber of individual regimes within classifications and the usage of different methodologies,with some economists also considering the behaviour of, among others, parallel exchangerates, interest rates, and the level of reserves. Frankel (2003) shows that the correlationsamong different de facto regime classifications are not very high.1 See, for example, Reinhart and Rogoff (2004). 3
  8. 8. Exchange Rate Regimes for Emerging Markets Chapter 2Figure 2: Exchange Rate Regimes a Exchange Rate Regimes (de facto)Dollarization and monetary unionCurrency boardFixed peg China* Jordan* Malaysia Venezuela MoroccoPeg within bands Hungary*+Crawling pegCrawling bandsManaged floating Argentina Czech Rep.+ Egypt India Indonesia Pakistan Peru+ Russia Thailand+Independently floating Brazil+ Chile+ Colombia+ Israel*+ Korea+ Mexico+ Philippines+ Poland+ South Turkey Africa+a. As of December 31, 2004.* The regime operating de facto in the country is different from its de jure regime.+ Monetary policy of inflation targeting.source: IMF The exchange rate regime classification of the IMF (Figure 2) consists of 8 differentregimes. The regimes are ordered by the rigidness of their exchange rate. The regimes at thetop display the least amount of exchange rate variability, while descending in the order ofregimes is associated with a gain of exchange rate flexibility. Exchange rate regimes are oftengrouped into three general categories of regimes: fixed, intermediate, and floating. Hard pegs,i.e. dollarized economies, monetary unions and currency boards, belong to the fixed category.Pegs within bands, crawling pegs, and crawling bands are considered intermediate regimes, whilemanaged and free floats would make up the floating category. Assigning fixed pegs to a group isthe most difficult task, as they could be assigned to either the fixed or intermediate category. Reviewing the classification of the emerging markets, it is obvious that the majority havedecided for floating regimes, while at the other end, no hard pegs are in place (anymore).However, empirical evidence indicates that emerging markets float in a different way thanadvanced countries by trying to limit their exchange rate swings, thereby often resembling thebehaviour of less flexible regimes2. In the following, I will not refer to specific exchange rate regimes, but rather discuss theadvantages of fixed and flexible regimes as well as conditions and developments favoring fixed orflexible exchange rates and/or increased stability or flexibility.2 See Calvo and Reinhart (2002) and Hausmann et al. (2000). 4
  9. 9. Exchange Rate Regimes for Emerging Markets Chapter 33. Fixed versus Flexible One of the principle insights of the Mundell-Fleming model3, and macroeconomic theory ingeneral, is the hypothesis of the impossible trinity: a country cannot simultaneously have afixed exchange rate, unrestricted capital mobility, and an independent monetary policy. Itmust choose two out of three. Given that the choice of capital controls is rarely chosen, thechoice effectively boils down to a trade-off between exchange rate stability and flexibilityprovided by an independent monetary and exchange rate policy. However, as Frankel (1999)notes, the implications of the impossible trinity do not compel an economy to choose betweenstability and flexibility per se. Rather an economy is free to opt for an in-between(intermediate) solution, for example by limiting the magnitude of exchange rate swings ordefending an exchange rate peg only to the extent that it does not interfere with othermacroeconomic objectives. The advantages of stability decrease with the amount of flexibilitya regime exhibits, while in turn the advantages of flexibility decrease with the rigidity of theexchange rate. Unless otherwise noted, I will be assuming high capital mobility withoutcapital controls throughout my paper. Absolutely fixed exchange rate regimes or hard pegs, i.e. currency unions, unilateralcurrency unions (dollarization), and to a certain extent currency boards (depending on theirreserve requirements) guarantee a fixed exchange rate through the adoption or creation of aforeign currency as legal tender, or in the case of currency boards through a conversion ratethat is fixed by law. An exit from the regime and the exchange rate parity is associated withlarge economic costs and political difficulties, so that the public views a (voluntary) departureas highly unlikely (Ghosh et al., 2002). Hard pegs are based on a simple monetary policy rule:changes in the monetary base are determined by the balance of payments account(Williamson, 1995, Schuler, 2000). A deficit contracts the money supply, while a surplusenlarges it. Adopting a hard peg means that an economy loses its ability to create money(monetary unions) or it is severely constrained (currency boards) and that domestic interestrates are tied to the rates in the anchor country through interest rate parity. Thus, an economymust sacrifice its monetary sovereignty and accept the monetary policy of the country itpegged its currency to in order to fix its exchange rate.3 Mundell (1963) and Fleming (1962) 5
  10. 10. Exchange Rate Regimes for Emerging Markets Chapter 3Figure 3: Balance Sheets of Currency Boards and Central Banks Currency board Central BankAssets Liabilities Assets LiabilitiesForeign reserves Cash Foreign reserves Cash Net worth Domestic assets/credit Deposits ofsource: Williamson (government debt) noncommercial banks(1995) Net worth source: Williamson (1995) Intermediate regimes provide a solution for economies that are unwilling to totally give upon an independent monetary policy but are equally unwilling to face large exchange rateswings. As mentioned above an economy can choose the degree of flexibility/stability bestsuited to its needs. In this context a regime that is/was often chosen is a fixed but adjustableexchange rate regime (FBAR). In contrast to hard pegs, where the monetary authority onlyhas foreign reserves at its disposal, or no reserves at all in the case of dollarization, under aFBAR the central bank has a foreign and a domestic component to its reserves (Figure 3),which allows the central bank to manage the exchange rate. When the fixed exchange ratecomes under pressure of depreciating (appreciating), the central bank can sell (buy) foreignreserves to support the exchange rate. However, the ability to defend the exchange rate islimited to the amount of foreign reserves an economy possesses. In the case of strong marketpressures or fundamental macroeconomic disequilibria, FBARs have an escape clauseallowing them to adjust the exchange rate (Ghosh et al., 2002). This option, however, shouldonly be chosen in emergency cases, as frequent exchange rate readjustments undermine thecredibility of the exchange rate peg (Corden, 2002). Under a purely floating exchange rate the domestic monetary authority is indifferent tochanges of the exchange rate. Having no preference for a particular exchange rate, there is noneed for the central bank to intervene in the foreign exchange market and, hence, there istheoretically no need for a large stock of foreign reserves (Ghosh et al., 2002). However, asmany economists note, pure floaters exist only in economic theory. Thus, even under floatingexchange rate regimes monetary policy is diverted to some extent to limit excessive exchangerate fluctuations. However, there is no particular commitment to a certain exchange rate andtherefore the exchange rate is much less of a constraint to monetary policy than under otherregimes. 6
  11. 11. Exchange Rate Regimes for Emerging Markets Chapter 33.1 The Case for and against Fixed Exchange Rates In the ensuing brief discussion of the advantages and the drawbacks of exchange rateregimes, I will focus on the polar extremes of absolutely fixed and purely floating exchangerates. One of the biggest advantages of fixed exchange rate regimes is their alleged ability to fightinflation. Fixing the exchange rate has been a way of quickly reducing inflation in countries withhigh inflation and a chronic inflation problem, such as Ecuador and Argentina. Several empiricalstudies have shown that (high) inflation is costly and impairs the economic growth of an economy.Adopting an ultimately fixed exchange rate regime provides a credible nominal anchor formonetary policy. By doing so, an economy imports the monetary policy of the country it pegged itscurrency to as well as its credible commitment to price stability. As a corollary, inflationexpectations are lowered to a level that is comparable with the anchor economy (Mishkin, 1999).The monetary rules of a hard peg preclude the conduct of an independent monetary policy, andconsequently an inflationary policy as well as the monetization of fiscal deficits. Thus, by fixingthe exchange rate to a low inflation, hard currency country an economy eliminates discretion,establishes monetary discipline, and ultimately will lower inflation expectations (Corden, 2002).Additionally a fixed exchange rate is a transparent and simple nominal anchor in comparison withother possibilities. It can be easily observed and verified by the public and thus will help to reduceuncertainty, which ultimately enhances the credibility towards price stability (Frankel, 2003). A further argument of advocates of fixed exchange rates is that fixed exchange rate regimes havea positive effect on trade. Short and middle-term exchange rate volatility often cannot beexplained by economic fundamentals, with excessive volatility posing a threat for the trade sectorof an economy (Corden, 2002). Hard pegs guarantee a fixed exchange rate, and thus minimize theexchange rate risk. As a result, transaction costs will fall and trade will be promoted as well asinvestment. In general, the harder the peg, and thus the less frequent exchange rate adjustmentsare, the greater the gains from trade will be. Naturally currency unions will create the greatestbenefits, due to the elimination of the exchange rate and transaction costs. In a study that hasreceived much attention due to its astonishing results, Frankel and Rose (2002), using data formore than 180 countries from 1970 to 1995, find that a common currency triples trade with closetrading partners. They also find that enhanced trade will lead to closer economic and financialintegration, especially with the anchor country, promote openness to trade and ultimately lead tohigher economic growth. Using a meta-analysis to examine the effect of currency unions on tradefrom thirty-four empirical studies, Rose (2004) finds a smaller effect of currency unions on trade 7
  12. 12. Exchange Rate Regimes for Emerging Markets Chapter 3than previously, ranging from over 30% up to 90%, but the results nonetheless indicate a strongpositive relationship between currency unions and trade. While empirical evidence suggests thatcurrency unions enhance trade, the (negative) link between exchange rate volatility and trade isless clear-cut. A number of studies find no statistically significant relationship4 and in the caseswhere studies do find a relationship, the effect is relatively small, with the consensus estimatebeing that the total elimination of exchange rate volatility would lead to a roughly 10% increase oftrade in industrialized countries (U.K. Treasury, 2003). However, it does seem sensible thatcountries with intensive trade ties or countries wishing to intensify their trade ties would favour afixed exchange rate. A third advantage often mentioned in economic literature is that hard pegs will lower realinterest rates (Berg and Borensztein, 2000). By fixing the exchange rate the expected likelihood ofdepreciations is reduced and with it the currency risk component of domestic interest rates. Lowerinterest rates together with lower inflation would promote investment, lead to an expansion anddeepening of the financial sector and would also reduce debt-servicing costs of the government.With the currency risk component depending on the likelihood of a future devaluation, here toothe general rule of the harder the peg the greater the benefit applies. Advocates of fixed exchangerates cite the example of Panama, a dollarized economy, where the nominal interest rates andinterest rate spreads have been persistently lower than in most other Latin American countries,while real interest rates have been low and steady (Schuler, 2000). The inability to pursue an independent monetary policy is the principal drawback of fixedexchange rate regimes, as its makes them vulnerable to negative shocks.5 Under fixed exchangerates and complete capital mobility, expansionary monetary policy has no effect on the economy.The additional liquidity created leaves the economy via a balance of payments deficit. In the caseof a real negative shock, which will require an adjustment of the real exchange rate, the effects ofan economic downturn cannot be corrected by a depreciation of the currency. As a consequencethe downward adjustment must be borne by wages and prices, which inevitably leads to a higherand longer economic contraction than under a flexible exchange rate regime (Frankel, 1999).Furthermore, the imported monetary policy can be the source of disturbance in the form of anasymmetric shock. If the fixed country and the anchor country are at quite different positions intheir business cycles, then the fixed economy could face an increase of interest rates although adecline would be required (Goldstein, 2002). In addition, the common monetary policy has the4 See, for example, Clark et al. (2004)5 Based on the realistic assumption that nominal wages and prices are sluggish and somewhat inflexibledownwards. In the case of a positive shock the outcome does not depend on the exchange rate regime (Corden(2002). 8
  13. 13. Exchange Rate Regimes for Emerging Markets Chapter 3effect that the fixed economy cannot insulate itself from shocks to the anchor economy (Mishkin,1999). A second disadvantage is the danger of the fixed exchange rate becoming misaligned and thedifficulties associated with restoring an exchange rate that corresponds to the economicfundamentals (Calvo and Mishkin, 2003). Recent experiences of countries adopting a hard peg,among others Ecuador, Argentina and Estonia, show that they experienced significant realappreciation in the first years of implementation, due to higher inflation than in the anchoreconomy6. A correction of the real exchange rate would call for a decline in nominal prices andwages or a lower rate of inflation than in the anchor economy, both of which, if feasible at all,would put a strain on economic growth. Thus, misalignment problems are more of a concern forcountries with low flexibility in wages and prices. An additional problem is those large exchangerate misalignments will inevitably increase the chances of a speculative attack (Ghosh et al.,2002). Using taxes and imports could function as a substitute for wages and prices to achieveadjustment of the real exchange rate. However, fiscal institutions in most emerging markets areprobably not up to the task (Calvo and Mishkin, 2003). An issue that concerns hard pegs to a lesser extent but merits consideration nonetheless is thesusceptibility of fixed regimes with a less credible commitment to a fixed exchange rate, i.e.intermediate regimes, to speculative attacks on their domestic currency, as episodes in the lastdecade have shown (Mishkin, 1999, Corden, 2002). A speculative attack challenges a country’scommitment to the fixed exchange rate. A country can defend its exchange rate by selling foreignexchange out of its reserves or by raising the interest rate. However, foreign reserves are limitedand raising interest rates has adverse effects on the economy and especially on the banking sector,so that an economy might see itself forced to devalue its currency. Empirical evidence indicatesthat in emerging market economies rigid regimes have had a higher incidence of banking andcurrency crises (Rogoff et al., 2003).3.2 The Case for and against Floating Exchange Rates The main advantage of floating exchange rate regimes is the principal drawback of fixedregimes, namely the ability to pursue an independent monetary policy suited to the needs of thedomestic economy. In contrast to fixed regimes, interest rates can be set independently, at least intheory. Furthermore, flexible exchange rates provide better insulation from negative external andreal shocks, due to the fact that the nominal exchange rate is quicker to respond than domestic 6 See Ghosh, Gulde and Wolf (1998, 2002) and Lopez (2002). 9
  14. 14. Exchange Rate Regimes for Emerging Markets Chapter 3prices and wages, for any given shock (Corden, 2002). Exchange rate flexibility allows aneconomy to respond to a negative external/real shock by increasing the monetary base, leading toa depreciation of the domestic currency, which will provide a stimulus for the domestic economy.While these measures probably will not be able to avoid a recession, it would be shorter and lesspronounced than under fixed exchange rates (Frankel, 1999). A second similar advantage is that even when the economy does not pursue a discretionarypolicy, floating exchange rates provide an automatic stabilizer for an economy against shocksaffecting the terms of trade (Frankel, 2003). If the international demand for a country’s productsfalls, so will its currency. In turn, a depreciated currency will help compensate for the fall ininternational demand. Floating regimes often entail large exchange rate swings, which cause the exchange rate risk andtransaction costs to rise, and thereby discourage trade and investment. But, as Corden (2002)explains, smoothing the exchange rate is not always the proper decision. If excessive exchangerate volatility is caused by changes and developments of the economic fundamentals thanexchange rate swings are “justified” and should be tolerated. However, if changing marketexpectations and herd behaviour by investors/speculators rather than economic fundamentals arethe cause for volatility in the exchange rate, which would appear to be the majority of cases, thanby adopting a regime of fixed exchange rates one would alter market expectations and thus wouldincrease the stability of the system. In contrast, a flexible exchange rates regime would merelytranslate exchange rate volatility into interest rate volatility, which would not be a significantimprovement from a macroeconomic point of view (Corden, 2002). Fixed exchange rate regimes seem to have a slight edge against flexible regimes regarding pricestability. In regimes with flexible rates the exchange rate cannot serve as a nominal anchor.Instead the most popular (and successful) choice is to define an inflation target as the nominalanchor. In contrast to hard pegs, under inflation targeting the possibilities of an inflationarymonetary policy and monetization of fiscal deficits cannot be totally ruled out, which is adisadvantage, especially in many emerging market economies with their histories of monetary andfiscal mismanagement. An additional factor speaking for exchange rate pegs is that they aresomewhat easier to monitor and verify than inflation targets (Corden, 2002).3.2.1. Inflation Targeting Adopting a flexible exchange rate regime narrows the choice of possible nominal anchorsfor monetary policy. To be more precise, there are basically two possibilities: a monetary 10
  15. 15. Exchange Rate Regimes for Emerging Markets Chapter 3target or an inflation target. Among emerging markets the latter has gained popularity and isto date associated with 13 countries (Figure 2), notably all freely floating regimes except forTurkey. Mishkin (2000, p.1) defines the 5 main elements of an inflation targeting monetary policystrategy as follows: “1) The public announcement of medium-term numerical targets forinflation; 2) an institutional commitment to price stability as the primary goal of monetarypolicy, to which other goals are subordinated; 3) an information inclusive strategy in whichmany variables, and not just monetary aggregates or the exchange rate, are used for decidingthe setting of policy instruments; 4) increased transparency of the monetary policy strategythrough communication with the public and the markets about the plans, objectives, anddecisions of the monetary authorities; and 5) increased accountability of the central bank forattaining its inflation objectives.” The main issue of monetary policy under floating exchange rates is the commitment to pricestability. Under inflation targeting, the monetary authority seeks to achieve the predefined level ofinflation by varying the short-term interest rates. A specific feature of inflation targeting that helpsto achieve price stability is its simplicity and observability. Assisted by a good communicationpolicy, monetary policy becomes comprehensible and transparent for a broad public, as they caneasily track the monetary authority’s success. However, for the commitment to price stability tobe successful an independent central bank is necessary, which is not constrained by fiscal orgovernment considerations and is autonomously in charge of monetary policy instruments(Masson et al., 1997). While price stability is the overriding policy objective, inflationtargeting allows enough discretion to deal with other objectives, such as limiting excessiveexchange rate swings and reducing output volatility (Mishkin, 2004). Inflation targetingundoubtedly has its virtues, but it also has its drawbacks. A problem in the conduct of inflationtargeting is that inflation is not easily controlled by the central bank. Moreover, economiesstarting from a high level of inflation will experience much more difficulties lowering andsubsequently stabilizing inflation, suggesting that inflation targeting should be implemented aftersome successful disinflation (Masson et al., 1997). A second difficulty arises due to the varyingtime lags from the adjustment of the interest rate to the subsequent effect it has on the inflationrate (Corden, 2002). Thus, short-term variations from the target can occur even in the case ofproper policy implementation. In the long-term though, short-term variations (caused by timelags) alone should not endanger a well-conducted inflation targeting policy. Skeptics, such as Masson et al. (1997), doubt that some emerging markets have the ability andwillingness to conduct a successful inflation targeting policy. Masson et al. (1997) see therelatively high income from seigniorage as a manifestation of fiscal dominance and, hence, 11
  16. 16. Exchange Rate Regimes for Emerging Markets Chapter 3lacking independence of central banks. Moreover, the authors argue that there seems to be noconsensus that low inflation should be the overriding objective of monetary policy in manydeveloping countries and emerging markets. High initial rates of inflation and fragile financialsystems are viewed as a serious impediment to a successful implementation and conduct ofinflation targeting. However, the authors also find that a strengthening of institutions may turninflation targeting into an attractive option for some developing countries and emerging marketsin the future.3.3 Lender of Last Resort Among economists there seems to be no overall consensus on whether the lacking lender of lastresort (LOLR) capability of fixed exchange rate regimes is actually an advantage or adisadvantage. As is generally known, hard peg regimes cannot independently set their moneysupply. This facts turns out to be a double-edged sword. While this helps in preventing inflation, itmay be harmful for financial stability, since extended domestic credit cannot be provided in timesof crisis. In this context, Larrain and Velasco (2001, p32) suggest: “The price of low inflation maybe endemic financial instability.” Proponents of flexible regimes stress the importance of bail-outs in the case of bank runs andfinancial turmoil, in order to prevent a full-fledged financial crisis from happening. Moreover,they believe that the loss of LOLR function may increase financial instability by augmenting theprobability of a banking crisis in countries with weak institutions (Volbert and Loef, 2002). On the other hand, advocates of fixed regimes believe that the importance of the lender of lastresort function under flexible exchange rates is overestimated (Calvo and Mishkin, 2003, Lopez,2002). They doubt that emerging market central banks can perform the LOLR ability as well astheir counterparts in industrialized economies for 2 main reasons. The first is that most emergingmarkets do not have sufficient foreign reserves (Salvatore, 2002), and more importantly second,most monetary institutions lack the required credibility to be an efficient lender of last resort. Inan industrialized country the central bank can issue excess liquidity and inject it into the frailbanking system. Due to the credibility of the central bank, the additional money supply is believedto be temporary and will be withdrawn when the time is ripe. In contrast, in developing countrieswith past inflation problems the liquidity infusion is not believed to be temporary, which in turnraises inflation and depreciation expectations, ultimately exacerbating, rather than easing, thealready critical situation (Mishkin, 1999). Another line of thought is that by depriving the central bank of its LOLR ability, fixed exchangerate regimes can avoid or at lest reduce moral hazard problems such as excessive risk taking bythe banks (Lopez, 2002). As a result, the chances that a situation of financial turmoil arises 12
  17. 17. Exchange Rate Regimes for Emerging Markets Chapter 3decline, thereby lessening the need for a LOLR altogether. In case that a financial crisis doesarise, the LOLR ability could be performed by commercial banks. Advocates of hard pegscontend that they will lead to higher financial integration and consequently result in a highernumber of international banks. Their argument is that in the event of a bank run, it is assumablethat foreign banks would bail out their local branches (Larrain and Velasco, 2001). However,if this is sufficient to stabilize the financial sector is arguable. Contingent credit lines, rigorous reserve requirements for domestic commercial banks, andinternational borrowing are the other main possibilities for economies with fixed exchange ratesto deal with situations of financial instability. But compared with the possibility of moneycreation, these alternatives appear to be inferior due to the different drawbacks each entail, such ashigher costs, questionable availability, possibly insufficient amounts of credit, and time lags(Goldstein, 2002). Ultimately, it seems that the ability to conduct an effective lender of last resort function underflexible exchange rates depends on the credibility and the quality of the involved institutions(Calvo and Mishkin, 2003). Thus, only if emerging market central banks have the requiredcredibility can the LOLR function be an advantage for flexible regimes.3.4 Fiscal Policy In the context of exchange rate regimes fiscal policy can take more than one role. While fiscalpolicy can be used as a government instrument to stabilize the economy, it can also be a source ofdisturbance when the fiscal budget gets out of hand.3.4.1. Fiscal Policy as the Problem A recurring reason for exchange rate and financial instability among emerging markets in thepast, especially in Latin America, has been the prevalence of fiscal dominance, where “the fiscaldeficit determines the money growth rate, and the money growth rate determines the rate ofinflation of domestic wages and prices” (Corden, 2002, p.109). A thing that fixed exchange rateregimes and flexible regimes under inflation targeting have in common is that both regimes arenot sustainable with large fiscal deficits (Mishkin, 2000). However, unsound fiscal policies pose abigger threat to fixed regimes. While under flexible regimes the inflation target cannot beachieved, thereby nagging on the credibility of monetary institutions, the exchange rate at leastprovides a certain amount of flexibility to deal with the situation. Whereas under fixed exchangerates, large fiscal deficits jeopardize the viability of the peg. Continuous high fiscal deficits willlead ceteris paribus to a deterioration of the current account balance, which will steadily increasethe borrowing costs for the domestic economy or force it to monetize its deficits (Corden, 2002). 13
  18. 18. Exchange Rate Regimes for Emerging Markets Chapter 3In order to correct the situation the fixed exchange rate must be given up and a more flexibleregime must be installed to reduce the fiscal deficit. Conventional wisdom has it that fixed exchange rates are better suited to generate fiscaldiscipline. Under hard pegs the possibility of monetization of fiscal deficits is ruled out. Insteadforeign reserves must be used to compensate a fiscal deficit. Foreign reserves are limited, and alower level could jeopardize the sustainability of the fixed exchange rate. A collapse of the pegwould entail large economic and political costs and surely put an end to the reign of thepolicymakers in charge. Thus, one would assume that policymakers, for their own sake, take aprudent approach to fiscal expenditure (Larrain and Velasco, 2001). However, funding of fiscaldeficits must not affect foreign reserves. Deficits also can be financed through governmentissuance of public bonds. Thus, a hard exchange rate peg does not rule out the possibility of alarge fiscal deficit. The example of Argentina, which ultimately defaulted on its debt, provesevidence that hard pegs are by far not a guarantee for solid fiscal policies (Calvo and Mishkin,2003). According to proponents of flexible rates “the combination of a flexible exchange rate andcapital mobility provides the most effective form of discipline” (Corden 2002, p.113). Tornelland Velasco (2000) argue that key difference between fixed and flexible regime is in theintertemporal distribution of the costs of imprudent fiscal behaviour. In contrast to fixedexchange rate regimes, lax fiscal policies under flexible regimes have an immediate impact onthe economy by altering the exchange rate and the price level. These costs must be taken intoconsideration by the policymakers in charge, giving them an incentive to balance the budget.Alternatively under fixed rates, lax fiscal policies affect the level of debt and/or foreignreserves, which effectively hide the costs from the public and push them into the future. It isonly when the amount of debt or reserves reaches a critical level, which questions thesustainability of the peg, that the effective costs are borne. Thus, considering the relative shortaverage duration of pegs, as well as the political instability in many emerging marketeconomies, the effective costs of fiscal profligacy under fixed exchange rates might have to borneby the next generation of policymakers, thereby providing little incentive for fiscal discipline forthe present generation. The empirical evidence regarding the effect of exchange rate regimes on fiscal discipline ismixed.7 However, reviewing the empirical results, which point in both directions, theconclusions drawn by the IMF (2001, p143) seem to be the most instructive from my point ofview. “History points to episodes of significant loosening of fiscal policies under currency7 See, for example, Tornell and Velasco (2000) for a “flexible point of view” or Ghosh, Gulde, and Wolf (1998)for a “fixed point of view”. 14
  19. 19. Exchange Rate Regimes for Emerging Markets Chapter 3boards, central bank independence, and partial and even full dollarization; moreover,significant reductions in fiscal deficits in several countries that adopted inflation targeting inrecent years are yet to be seen. This suggests that monetary (exchange rate) arrangements perse have only limited power to fix “real” problems arising from a fiscal regime inconsistentwith the goal of price stability.”3.4.2. Fiscal Policy as an Instrument While fixed exchange rate regimes do not possess the ability to use monetary policy as aninstrument for macroeconomic purposes, they are still left with an instrument at their disposal,namely fiscal policy. A successful active fiscal policy provides fixed exchange rate regimes withan instrument to deal with negative shocks and resulting economic downturns, thereby moderatingtheir principal weakness (Corden, 2002). However, fiscal policy is not a replacement for monetary policy. The main distinction betweenthe 2 policies is that: “Fiscal policy is financing while exchange rate depreciation is adjustment”(Corden, 2002, p.98). A successful fiscal policy used as an instrument to stabilize the economyrequires the government budget to be balanced in the long-term, otherwise the fiscal deficit willbecome a burden to the economy. This means that increases in public spending will eventuallyhave to be reversed and, hence, can only be a temporary stimulus to the economy. Thus, fiscalmeasures do not lead to a new equilibrium as in the case of monetary/exchange rate policy, butthey can provide temporary relief from negative shocks (Corden, 2002). There are a number of difficulties that arise when trying to use fiscal policy as a countercyclicalinstrument in fixed exchange rate regimes. First, assuming that fiscal policy is primarilyimplemented countercyclical, an economy choosing to expand fiscal expenditures must be able toacquire fiscal surpluses in times of economic prosperity in order to budget its balance. However,as only few emerging market economies have been able to record fiscal surpluses in recent years(table 2) the option of fiscal expansion should be regarded with caution (Corden, 2002). Second,emerging market economies with high initial levels of public debt (table 7) will probably be notwilling to deliberately expand public spending. The disadvantages, such as an increase of theborrowing costs, and concerns over inflationary finance as well as the sustainability of theexchange rate peg, could weigh too heavy (Goldstein, 2002). Third, even if an economy canproduce fiscal surpluses and has a strong debt position, the implementation of an anticyclicalfiscal policy might fail due to the reluctance of politicians. In an economic downturn mostpoliticians tend to lower fiscal expenditure, convincing them to do the opposite will surely not beaccepted unanimously (Corden, 2002). 15
  20. 20. Exchange Rate Regimes for Emerging Markets Chapter 4Countercylical fiscal policy can temporarily weaken the effects of a recession, which wouldspeak in favour of fixed exchange rates. But the conditions for a successful implementation do notseem to coincide with the characteristics of most emerging market economies, implicating thatmost emerging markets are not able to deliberately use fiscal policy as an instrument.4. The Theory on the Choice of Exchange Rate Regime After giving a brief overview on the principal advantages and drawbacks of fixed andflexible regimes, in this section I focus on country characteristics that favour either flexibilityor stability. In the following discussion of specific criteria and characteristics, conclusions thatare drawn will be based solely on the particular characteristic in focus. Unless otherwise noted, Iwill always be assuming that other factors will remain equal. When forming a decision on the choice of an exchange rate regime it is necessary to view thewhole picture and not to focus on particular country characteristics. A country’s characteristicsprimarily dictate if the advantages of a fixed or a floating regime will prevail. In every countrythere will be certain factors that speak for and against the adoption of a certain exchange rateregime, and not everywhere will the same factors be of equal importance. Thus, in the debate onthe choice of exchange rate regime one size does not fit all (Calvo and Mishkin, 2003).Furthermore, policymakers should be aware that country characteristics are subject to changesover time, so that the ideal regime for today need not be the ideal regime for tomorrow (Frankel1999). Additionally, countries should verify their ability to adopt a particular regime, notably theimplementation of a hard peg, i.e. dollarization or a currency board, requires a high stock offoreign reserves (Goldstein, 2002). Last but not least, besides all the economic, political, andgeographical criteria involved in such a decision, one should not forget to consider the possiblymost important factor of all, namely the public’s will. Even the “optimal” exchange rate regime isdoomed to fail if it does not have the public’s backing and approval. Economic literature states a vast number of criteria that influence the choice of exchange rateregime. A traditional criterion that is usually mentioned first in the debate of fixed-versus-floatingis the nature of shocks. According to the Mundell-Fleming framework an economy thatpredominantly encounters domestic nominal disturbances is better off adopting some sort of fixedregime. The rigid nominal exchange rate prevents monetary shocks from having realconsequences. On the contrary, if real and/or external shocks are the main cause of concern for aneconomy, then a floating regime seems to be the better choice. The required change in relative 16
  21. 21. Exchange Rate Regimes for Emerging Markets Chapter 4prices can be achieved more rapidly by adjusting the nominal exchange rate, thereby limiting thenegative effects on the real economy.Thus, following the Mundell-Fleming approach, one would expect to see countries, which aresubject to large real shocks to have some sort of flexible regime in place. Furthermore, theobserved increase of capital mobility in recent years (IMF, 2005a) can be viewed as an indicatorthat the significance of real shocks is growing. But, contrary to economic theory empiricalevidence is less clear-cut. Hausmann et al. (1999) refer to a number of studies that find thatincreased terms of trade variability is associated with a higher probability of adopting a fixedexchange rate. They see the reason for this behaviour in the deeper financial markets that fixedexchange rate regimes allegedly provide.8 On the other hand, findings by Broda (2003, 2004) andEdwards and Levy-Yeyati (2003) support the conventional view that negative real shocks have alarger impact on the output of fixed exchange rate regimes.9 Additionally the authors show thepresence of asymmetries in price behaviour (downward nominal inflexibility), slower realexchange adjustment under pegs, and that terms-of-trade disturbances account for a higher extentof real GDP fluctuations in developing countries under pegs (33%) than under floats (15%).4.1. Optimal Currency Area Criteria A further traditional approach that takes many relevant country characteristics into account is thetheory of Optimal Currency Areas (OCA) developed by Mundell (1961) and McKinnon (1963).The OCA theory focuses on a country’s geographical and trade features and provides a frameworkto evaluate which countries/regions are best suited to share a common currency and a commonmonetary policy. Frankel (1999, p.14) defines an OCA as “a region that is neither so small andopen that it would be better off pegging its currency to a neighbor, nor so large that it would bebetter off splitting into subregions with different currencies.” At the heart of the OCA approach isthe insight that the benefits of a fixed exchange rate increase the more 2 countries trade with eachother. The principal reason speaking against the realization of an OCA is its vulnerability toasymmetric shocks. But even in the presence of asymmetric shocks there are factors that canmitigate their adverse effects, so that it might still be beneficial for an economy to adopt a fixedexchange rate. In the following, I will give an overview of the OCA criteria and how theyinfluence the choice of exchange rate regime.8 Hausmann et al. (1999, p8) argue that: „fixed exchange rate regimes should result in deeper financial markets,which should be particularly important in economies facing important terms of trade shocks.”9 Broda (2004) focusing on developing countries, finds that a 10% fall in the terms of trade reduces real GDP by1.9% in pegs and by 0.2% in floats, while Edwards and Levy-Yeyati studying a sample of 183 countries find areal GDP reduction of 0.4% for floats and 0.8% for pegs. 17
  22. 22. Exchange Rate Regimes for Emerging Markets Chapter 4 Openness and size: A crucial role in the choice of regime plays the degree of openness to trade,which can be interpreted as a measure of economic integration (Frankel, 2003), a country exhibits.There are principally three ways that openness directly affects the choice of exchange rate regime.First, the higher the degree of income that an economy earns through trade, the larger will be theadverse effects resulting from exchange rate variability (Corden, 2002). Thus, open countriesseeking to stabilize their output should adopt some form of fixed exchange rate regime. Second,since international trade between developing and developed countries is principally invoiced inthe stronger currency (McKinnon, 1999, Goldberg and Tille, 2004), nominal wages and prices in avery open economy are likely to be denominated in a foreign currency or to be linked to theexchange rate (Corden, 2002). Currency substitution and/or indexation impede the effectivenessof a discretionary monetary policy and thereby strengthen the case for fixed exchange rates10.Third, the more open an economy is, the less it needs a flexible exchange rate as a shock absorber(Corden, 2002). An open economy will display a high marginal propensity to imports. In the caseof a fall of demand resulting form a negative shock, the higher the marginal propensity to importsis, the smaller the effect on domestic nontradables will be, and thus, the lower the resultingunemployment. Thus, based solely on the OCA criterion of openness, the advantages of fixedexchange rates seem to overweigh and consequently a fixed regime would seem to be the superiorchoice for an economy with a large trade sector. Indeed, the fixed pegs among the 25 emerging market economies display a higher degree ofaverage openness11 than the rest (table 3 and figure 4). However, Morocco and Venezuela do notexhibit a high degree of openness, while the significantly more open economies of the Philippinesand Thailand have floating regimes in place, indicating that there are factors other than opennessinfluencing the choice of exchange rate regime.10 I will discuss the effect of indexation and currency substitution on monetary policy in more detail further below.11 Measured as the average of exports and imports in percent of GDP. 18
  23. 23. Exchange Rate Regimes for Emerging Markets Chapter 4Figure 4: Openness of Fixed Pegs Openness of Fixed Pegs 2004 (in % of GDP) 120 100 80 60 40 20 0 1 Malaysia Jordan China Morocco Venezuela average of other EMs Source: World Bank, World Development Indicators Another way openness indirectly influences the choice of exchange rate regime is through thesize of an economy. Extremely open economies are likely to be very small economies and smalleconomies tend to be more open than larger economies (Corden, 2002). Additionally, the benefitsof having an independent currency increase with the number of users (Levy-Yeyati et al., 2004).Thus, one would assume for small economies to be better candidates for a regime of fixedexchange rates. Empirical evidence confirms theoretical predictions, with only one country among15 dollarizers and 7 currency boards having a population over 10 million (Ecuador) and theaverage population being approximately 3 million. Geographical concentration of trade: While the extent of trade is the most important factor indetermining if a country should peg its currency, the geographical concentration of trade has to betaken into consideration as well (Larrain and Velasco, 2001). Countries that predominantlyconduct their trade with one major partner derive a greater benefit from pegging their currency (tothe partner country) than countries with a highly diversified trade base. Asymmetric shocks: Basic economic theory states that if 2 or more countries face similarshocks that require similar policy interventions, then the adoption of a fixed exchange rate and acommon monetary policy should not have far-reaching negative consequences for either region.On the other hand, if 2 countries face asymmetric shocks, a common monetary policy will not beable to suit both regions, and adjustments of the real exchange rate would be needed toaccommodate differences, which would call for flexible exchange rates. As a corollary, countriesconsidering pegging their currency should share a similar business cycle with their partnercountry to limit the incidence of asymmetric shocks (Frankel, 2003). Other OCA criteria: As mentioned above, even in the presence of asymmetric shocks there arefactors that can limit their magnitude under fixed exchange rates. High labour mobility, price and 19
  24. 24. Exchange Rate Regimes for Emerging Markets Chapter 4wage flexibility, as well as fiscal transfers each provide adjustment mechanisms to cope withasymmetric shocks in the absence of exchange rate flexibility (Frankel, 2003).Strategic considerations: The optimal exchange rate regime for a country does not only dependon its own characteristics, it also depends on the surrounding environment, in this case theexchange rate arrangements of neighbors, competitors, and trade partners. By pegging to a majorcurrency, currency risk can be eliminated with the anchor economy, but it also means that theeconomy is floating vis-à-vis all other currencies. This especially poses a problem for fixedeconomies in a “neighborhood” of floaters (Larrain and Velasco, 2001). In this context theexample of Argentina is instructive. In 1999, Brazil faced a large depreciation of its currency. Asa result Argentina suffered a large loss of international competitiveness vis-à-vis its main tradingpartner Brazil, which was one of the factors attributing to the severe recession and possibly to thecollapse of the currency board (Salvatore, 2002). Thus, one could assume that the number offloating regimes in geographic and economic proximity decreases the attractiveness of fixing theexchange rate. The Optimal Currency Area theory can provide some helpful insights in evaluating if a countryis a good candidate to join a monetary union or to fix its exchange rate. But an evaluation basedsolely on the OCA criteria would be incomplete. Moreover, the OCA theory also has itsdrawbacks. First, the European Monetary Union has managed to function successfully although itcertainly does not form an optimal currency area. This has led many economists to believe theOCA criteria are too stringent. “The point is that the requirements for having single moneydeveloped by the optimal currency literature are so demanding as to call into question manyexisting currency areas” (Fratianni and Hauskrecht, 2002, p.251-252). Second, the currency crisesin emerging market economies of the recent past have shown that international capital flows playan increasingly important role in an increasingly integrated world. Unfortunately the OCAapproach does not take the role of financial markets and capital flows into account. Third andmost importantly, the OCA approach fails to incorporate features and characteristics that arecrucial to emerging market economies, such as, among others, credibility issues, weakinstitutions, higher pass through effects and a dependency on foreign capital (Calvo and Mishkin,2003). For the reasons stated above, I would see the OCA approach more as a complementary tool inthe analysis and evaluation of exchange rate regime for emerging markets. In the next chapter Iwill discuss the problems that are specific to emerging market economies and how they mightinfluence the choice of exchange rate regime. 20
  25. 25. Exchange Rate Regimes for Emerging Markets Chapter 55. Emerging Market Issues In many ways emerging market economies are victims of their past. Many of them, especially inLatin America, have a history of high inflation owing primarily to the monetization of budgetdeficits. Other factors such as corruption, political instability and broken promises from themonetary authority have also certainly not encouraged price stability as well as economic stabilityand development. Such events have severely damaged the image and credibility of domesticinstitutions. Unfortunately, well-developed and well-run institutions are a necessary prerequisitefor the success of an exchange rate regime. Especially a credible central bank is crucial in order toconduct a successful monetary policy. Even if a firm commitment is made towards price stabilityand a “sound and correct” monetary policy is installed, this may not be enough to sufficientlylower the public’s inflation expectations, due to a large distrust from past events. The lack or lacking quality of political, fiscal, financial and monetary institutions paired withthe fact that large fluctuations in the exchange rate are more detrimental to the economies ofdeveloping countries than to those of industrial countries (Salvatore, 2002, Corden, 2002), hasled many economists in the past to believe that developing countries and emerging marketeconomies have little to gain from a flexible exchange rate and an independent monetarypolicy and, thus, would be better off adopting a foreign monetary policy and thereby fixingtheir exchange rate. However, at first sight, recent trends in the popularity of exchange rateregimes do not seem to support this view (Hakura, 2005, Frankel, 2003). Frankel (2003), forexample, observes a clear trend toward increased flexibility over the last 30 years, with thevast majority of regimes being classified as intermediate. Unfortunately, these findings arebased on a de jure classification, with the actual/de facto behaviour of regimes not necessarilycorresponding to their classification. In reality many as managed floating or floatingannounced regimes have shown a reluctance to let their exchange rate swing (freely), dubbedas “fear of floating” by Calvo and Reinhart (2002) (table 11 and 12). But, as Calvo andReinhart (2002) note, it is very difficult to distinguish exchange rate regimes in general, andregimes in the intermediate border region, say a managed float from a soft peg, in particular.Nonetheless, empirical evidence indicates that floating exchange rate regimes in emergingmarkets are more rigid than in their industrial counterparts and their de facto behaviourindicates that they, to a certain extent, have been importing the monetary policy andcredibility of foreign countries, thereby deliberately limiting the advantages of flexibility. 21
  26. 26. Exchange Rate Regimes for Emerging Markets Chapter 55.1. Credibility A central issue in the debate on exchange rate regimes in emerging markets is the credibility ofdomestic institutions, especially the credibility of the central bank’s commitment to price stability.Blinder (1999, p.1) offers a simple definition of credibility: “A central bank is credible if peoplebelieve it will do what it says.” Thus, credibility cannot be measured in statistical terms. However,inflation performance and inflation history reveal a great deal about an economy’s credibility. Pastmistakes and failures have nagged on the credibility of monetary institutions in emerging marketsand have negatively influenced expectations and behaviour of the public. The credibility of themonetary authority, however, does not only depend on its own actions, it also hinges on thequality of the other institutions. For instance, large fiscal deficits, an ill-supervised bankingsystem and political instability all could cause large damage to an economy, so that thecommitment towards price stability has to be subordinated to a stabilization policy, possiblycausing unwanted inflation. Unfortunately, every time the central bank fails to preserve (expected)price stability, it will become increasingly less credible. As a corollary, the public in countrieswith weak central bank credibility will not take the real value of money for granted (Calvo andMishkin, 2003) and eventually will protect themselves by, for example, using a foreign currencyas a store of value and/or indexing their wage contracts to the rate of inflation or the exchangerate. Moreover, high inflation and frequent depreciations of the domestic currency increasinglyundermine the effects of monetary policy on the real economy, while concomitantly increasing theeffects on inflation and nominal interest rates. Thus, for economies starting from a situation, where the public questions the credibility of themonetary authority, fixed exchange rate regimes hold an advantage over flexible regimes. Byimplementing a hard peg, an economy instantaneously imports the credibility and monetarystability of the country it pegged its currency to, helping to quickly reduce inflation. On the otherhand, flexible exchange rates will have to “build” that credibility by themselves, which is needlessto say by far the more difficult process (Larrain and Velasco, 2001). In contrast to hard pegs, thepossibility of inflationary finance can never be totally ruled out. Hence, for emerging marketcountries with recurring inflation problems an absolutely fixed regime can provide morecredibility than a floating regime (Corden, 2002). However, some economists question the desirability of fixed exchange rate regimes and see themas second best solutions, or rather as the consequence of economies with weak institutions that arenot able to solve their credibility problems on their own (Levy-Yeyati et al., 2004). “In the caseof unilateral dollarization or euroization, stability is imported because previously unstablecountries are not able to implement necessary monetary and fiscal reforms that lead to stable 22
  27. 27. Exchange Rate Regimes for Emerging Markets Chapter 5economic development on a credible and permanent basis”(Volbert and Loef, 2002, p306).Empirical results by Levy-Yeyati et al. (2004) suggest that the propensity to peg is higher fordeveloping economies with low institutional quality, relying on the exchange rate anchor tocompensate for low credibility. While the advocates of fixed exchange rates stress the inflation reducing capabilities of fixedexchange rate regimes due to the enhanced credibility and discipline, the adoption of such aregime for countries with high inflation is nonetheless somewhat of a paradox (IMF, 1997).Essentially high rates of inflation and a fixed exchange rate are not sustainable. Developingcountries with a fixed exchange rate and a higher rate of inflation than the country theypegged to will experience a real appreciation of their exchange rate, which reduces theirinternational competitiveness and also leads to a worsening of the current account (IMF,1997). As a result, the peg will become misaligned, putting pressure on the exchange rate andthe financial sector, eventually making an adjustment of the exchange rate inevitable. Therelative short duration of most exchange rate pegs12 indicates that fixing the exchange rateentails problems of its own, such as a loss of competitiveness, and is not an everlastingsolution for economies with credibility problems.Credibility problems per se can arise both under flexible and fixed exchange rate regimes. Butthey differ due to the different objectives of monetary policy.Under flexible exchange rates, the commitment to price stability determines the credibility ofmonetary policy. Thus, the monetary authority will have to convince the public that they are onlycommitted to the pursuit of their policy targets and that excessive inflation will not occur again.Under flexible exchange rates the best way to achieve this is by using an inflation targetingpolicy. Credibility enhancing measures include providing the public with detailed information oninflation results, targets and forecasts, current and future policies as well as possible obstacles(Mishkin, 1999). But ultimately, the credibility of flexible exchange rate regimes will increase thelonger they are successfully able to preserve price stability (Corden, 2002, Mishkin, 1999). In contrast to flexible regimes, under fixed exchange rates price stability is not a direct issue. Byfixing the exchange rate, an independent monetary policy is given up and the commitment to pricestability is imported with the monetary policy of the anchor currency country. Thus, the exchangerate serves as the nominal anchor for monetary policy and the credibility depends on thecommitment to the exchange rate peg, or put in other words, on the public’s perception of thechances that the fixed exchange rate will be abandoned. A high level of foreign reserves increasesa country’s ability to defend a fixed exchange rate and thereby enhances the credibility of the peg.12 See, for example, IMF (1997) 23
  28. 28. Exchange Rate Regimes for Emerging Markets Chapter 5But ultimately, the larger the economic and political costs associated with a collapse of the peg,the higher will the incentive be for the government to defend the regime, which in turn willincrease its credibility (Schuler, 2000). Credibility can also be seen as an indicator of the rigidnessof a fixed regime and vice versa, with hard pegs profiting from the benefits of high credibility andsoft pegs, with their escape clauses, profiting less from credibility but instead deriving benefitsfrom their enhanced flexibility (Schuler, 2000, Larrain and Velasco, 2001). The choice of exchange rate regime hinges to a great part on the credibility of a country’smonetary and the quality of its other institutions. Weak institutions and a central bank that lackscredibility towards price stability do not favour the adoption of flexible exchange rate regimes.However, a qualification must be noted, countries with large fiscal imbalances in the long-runhave no other choice than to opt for a regime with floating exchange rates (Corden, 2002).5.2. Access to International Financial Markets A problem that is linked to the lacking credibility of monetary and fiscal policies inemerging markets is their access to international financing compared with developedeconomies (Calvo and Reinhart, 2000). In the past, emerging market countries have been highlydependent on foreign international capital to finance their growth due to the relatively shallowdomestic financial markets (Calvo, 1999). Lower credibility translates into lower credit ratings,which in turn means emerging markets will have to offer higher interest rates in order toattract funds. Using the credit ratings of two internationally renowned agencies, Moody’s andInstitutional Investor, for a sample of 25 countries during a 30 year time period, Calvo andReinhart (2000) observe that the level of credit ratings for emerging markets is on average athird to half of that assigned to developed economies. Furthermore, the authors show thatfollowing a large devaluation of the domestic currency emerging markets experience a fargreater credit rating downgrade than developed economies.13 However, the devaluations andassociated credit downgrading are not always the result of weak domestic polices. They canbe caused by factors external to a domestic economy, most notably contagion, as theexperiences from past crises have shown (IMF, 2003). As a consequence of the lower creditrating international investors will demand a higher yield (Calvo and Reinhart, 2000) andemerging markets will face higher debt-servicing costs associated with a higher chance of13 “In the twelve months following the currency crisis, the magnitude of the downgrade is about five timesgreater for emerging markets than it is for developed economies. The differences between the post-crisisdowngrade for emerging and developed economies is significant at standard confidence levels. ” Calvo andReinhart (2000, p13) 24
  29. 29. Exchange Rate Regimes for Emerging Markets Chapter 5default and additionally putting considerable stress on the already rather weak financialsystem. Alternatively, if interest rates are not raised sufficiently, the emerging market will notbe able to attract foreign capital and the economic contraction will be more pronounced.Thus, devaluations in emerging markets lead to a limited access to international funds or toborrowing costs that might jeopardize the health of the financial system, both of which helpdeliver a possible explanation as to why emerging markets are reluctant to face largeexchange rate swings.5.3. Sudden Stops and Currency Crises While the incidence of sudden stops is neither a new nor a rare phenomenon, and certainlynot one that is limited to emerging market countries, sudden stop issues have really come tothe fore in context with the financial and currency crises to emerging market economies of thepast decade. The affected countries faced large devaluations of their currencies and thevolatility of capital flows became a serious problem as capital inflows ceased and in somecountries even reversed. While there are several different definitions of a sudden stop, asudden stop initially refers to a large decline in capital inflows to a country. However,economic literature tends to focus on the cases where a sudden stop in capital inflows isaccompanied by a contraction in output. The reasons for this decline in capital inflows canvary and be of domestic origin, such as political instability, banking and currency crises, or ofexternal origin, such as changes in international interest rates or contagion (Guidotti et al.,2004). However, the latter seems to be of greater importance as the incidences of emergingmarket sudden stops in the past decade were not uniformly distributed, but rather werebunched around periods of emerging market crises (Calvo et al., 2004). Furthermore,countries that were simultaneously affected by sudden stops were quite heterogeneous in theirmacroeconomic fundamentals as well as in their geographic location. To take a closer look at the effects of sudden stops, it is helpful to take a look at the nationaleconomic accounts:Y- E ≡ CA (NX)- CA + ∆R ≡ KA Where Y denotes income, E is absorption/aggregate demand, CA the current account, KAthe capital account, and ∆R the change in international reserves. 25
  30. 30. Exchange Rate Regimes for Emerging Markets Chapter 5 By definition, net capital inflows must match the current account deficit and the change ininternational reserves. Hence, a reduction in capital inflows, will result either in anamelioration of the current account and/or a loss of reserves. A reduction of reserves reducesa country’s capability to control its exchange rate, thereby increasing the likelihood ofspeculation and a currency crisis, while an amelioration of the current account in the wake ofa sudden stop is mostly compensated by a fall in aggregate demand and, thus, has negativeconsequences on employment and output (Calvo and Reinhart, 2000). Indeed, findings ofCalvo et al. (2004) support traditional economic theory, as they observe that sudden stops areassociated with reserve losses and large current account adjustment as well as large upswingsin interest rates. A key distinction between developing and developed countries is that empirical evidenceindicates that large real depreciations in emerging markets are usually associated with suddenstops, whereas in developed economies this phenomenon is rather rare (Calvo et al., 2004).This suggests “large real exchange rate fluctuations accompanied by sudden stops arebasically an emerging market phenomenon” (Calvo et al., 2004). Calvo and Reinhart (2000) investigate the effect of currency crises on the incidence andmagnitude of sudden stops, as well as the effect on output. They take a closer look at 96currency crises, of which 25 occurred in developed economies and the remaining 71 indeveloping countries. Regarding a two year time period for every currency crisis, with thefirst year preceding the crisis and the last succeeding it, the authors conclude that a currencycrisis leads to an improvement of the current account and a reduction of growth in both typesof economies. But, the authors also find that the magnitude of sudden stops, measured ascurrent account adjustment during the time period, and growth reduction differ significantlybetween developed and developing economies, both economically and statistically. Thedifference in current account adjustment is five times larger (3.5% compared to 0.7%) fordeveloping economies14, while the growth reduction is 2% compared to 0.2% for developedeconomies during the two year time period. The authors see the main reason for the largereconomic damage of currency crises and the occurrence of sudden stops in emerging marketsin their inability to generate sufficient funds, which is caused by the acute deterioration ofborrowing conditions and associated loss of access to international finance due to lower creditratings, and the relative shallow domestic financial markets.14 Guidotti et al. (2004) and Calvo et al. (2004) also find developing countries are associated with much largeradjustments in the current account than developed economies. 26
  31. 31. Exchange Rate Regimes for Emerging Markets Chapter 5 Looking for factors that influence the occurrence of sudden stops Frankel and Cavallo(2004) find that openness significantly reduces the probability and the associated costs of asudden stop (and currency crisis), whereas a large initial current account deficit increases theprobability. Calvo et al. (2004) find that trade openness (negatively) and domestic liabilitydollarization (positively) are the key determinants of the probability of sudden stops. WhileGuidotti et al. (2004) find that low levels of liability dollarization, floating exchange rates anda high level of openness are conducive to a rapid recovery from a sudden stop. Other factors influencing the incidence of sudden stops, such as political instability andcontagion, occur regardless of the exchange rate regime in place. However, as mentionedabove, currency crises often appear together with sudden stops and the former do seem to belinked to the choice of exchange rate regime (Mussa et al., 2000). Rogoff et al. (2003) using ade facto classification of exchange rate regimes find that twin (banking and currency) crises inemerging markets occurred more often in pegged regimes and that their incidence decreasedwith increasing flexibility of regimes.5.4. Trade Issues The standard trade invoicing rule among industrialized countries that goods tend to bedenominated in the currency of the exporting country (McKinnon, 1999) does not apply very wellto emerging market economies. Instead, international trade involving an emerging marketeconomy is usually invoiced in the currency of the larger economy. Moreover, very oftentrade among emerging market economies is invoiced in dollars or euros (Clark et al. 2004,30). Goldberg and Tille (2004) show that while the share of exports invoiced in the currencyof the exporter is above 90% for the United States, and above 50% for the UK, Germany andFrance, the emerging market economies of Korea and Thailand exhibit a share below 10%.Studies analyzing the effect of exchange rate variability on trade in emerging markets15 seemto lean towards the hypothesis that exchange rate variability has a negative effect on trade,which is arguably larger than in industrialized economies (Calvo and Reinhart, 2000). Clarket al. (2004) find that volatile exchange rates are more likely to be associated with smallertrade for developing countries than for advanced economies. However, their results are notvery robust; the introduction of time varying effects in the regression erodes the impact ofvolatility on trade flows. Arize et al. (2000, 2005) come to the conclusion that there is a15 For an overview of the literature, see Calvo and Reinhart (2000), p.16. 27
  32. 32. Exchange Rate Regimes for Emerging Markets Chapter 5negative and statistically significant relationship between export flows and exchange-ratevolatility in both the long- and short-run in each of the thirteen less developed countries andeight Latin American countries in their respective studies. Broda and Romalis (2003) find thatthe depressing effect of volatility on exports is greater for emerging markets than fordeveloped economies. While the reasons for the alleged vulnerability of emerging markets to swings in theexchange rate are manifold and could range from the trade invoicing patterns over limitedhedging possibilities to a higher risk adversity of exporters, empirical evidence suggests thatreducing exchange rate variability could enhance trade, especially for emerging markets.5.5 Effectiveness of Monetary Policy In the past, most emerging market economies and developing countries have not been able toderive a great profit from using discretionary monetary policy, or have used monetaryindependence for other purposes than in industrial countries. Hausmann et al. (1999) come to theconclusion that flexible exchange regimes neither deliver much insulation from shocks norprovide much room for monetary policy autonomy, while lacking the credibility of hard pegs. A history of high inflation and/or lacking central bank credibility have taken the “surprise” outof surprise inflation, so that countercyclical monetary policy does not have the desired effect onoutput and unemployment in many emerging market countries (Larrain and Velasco, 2001).Furthermore, the dependency of emerging markets on foreign capital and the higher volatility ofinternational capital flows complicate the conduct of a monetary policy. In times of economicdownturn, interest rates, and hence monetary policy, often do not take domestic considerationsinto account and behave in a procyclical manner to preclude an outflow of foreign capital and helpstabilize the exchange rate (Calvo and Reinhart, 2002). An additional difficulty has been that tax-collecting systems in many developing countries have proven to be inefficient and weak, with taxevasion being widespread. With the fiscal base being very small, a discretionary monetary policyoften has been misused in the past as an additional source of revenue through the inflation tax(Calvo and Reinhart, 2002).5.5.1. Monetary Independence Following conventional economic theory, one would expect monetary independence to begreater under floating exchange rates, as interest rates can be set independently and are not 28
  33. 33. Exchange Rate Regimes for Emerging Markets Chapter 5determined by foreign policies as in the case of fixed exchange rates (Frankel et al., 2002).However, empirical evidence is far less clear-cut than economic theory. Shambaugh (2004) finds evidence for the notion of the impossible trinity. In a sample of over100 developing countries divided into de facto pegs and non-pegs from 1973 through 2000, theauthor finds that the exchange rate regime along with capital controls seem to explain the extent towhich a country follows foreign interest rates. For developing countries pegging significantlyincreases sensitivity to foreign interest rates, while capital controls (for fixed regimes) do theopposite. Further important findings are that in pegged regimes interest rates are lower and morestable, while in non-pegged regimes foreign interest rates are not a good indicator of domesticmonetary policies, implying that these countries have a reasonable amount of monetary autonomy. Frankel et al. (2002) analysing a sample of 18 industrial and 28 developing countries over a timeperiod from 1970-1999 find that results for the entire sample confirm conventional wisdom, withfloating regimes displaying less sensitivity to foreign interest rates and fixed regimes displayinglower interest rates. However, in the 1990s both industrial and developing countries displayed fullor near-full adjustment of local interest rates to foreign interest rates, with fixed regimesdisplaying a significant over-adjustment. While developing countries, regardless of their regime,adjusted to interest rates set in the financial centres, countries with flexible rates did appear tohave a higher degree of monetary independence, albeit temporary, as hard pegs displayed aquicker adjustment than other regimes. In an attempt to measure monetary independence Borensztein et al. (2001) compare the currencyboards of Hong Kong and Argentina with the floating regimes of Singapore and Mexico duringthe 1990s. This country comparison entails the advantage that the country pairs share broadsimilarities and that classification problems can be circumvented, as the floaters do not exhibitmuch fear of floating. Additionally for benchmark purposes the authors include the industrializedfloating economies of Canada, Australia, and New Zealand as well as Chile. Using VAR modelsthe results obtained are broadly consistent with the view that floating regimes deliver moremonetary independence. While all 4 economies displayed a significant impact of changes in USinterest rates on domestic interest rates, the effect was significantly larger for the currency boards.Additionally, shocks to emerging market risk premia had smaller effects in Singapore than inHong Kong, however, contrary to the conventional view, interest rate reactions to such shockswere nearly identical in size for the economies of Mexico and Argentina. Hausmann et al. (1999)find that the reaction of domestic interest rates in 11 Latin American countries is similar acrossdifferent regimes for a time span from 1960-1998. Moreover, for a short 2-year time span from1998-1999, the authors find that changes in international risk premia had the largest effects on 29
  34. 34. Exchange Rate Regimes for Emerging Markets Chapter 5interest rates in the floating regime of Mexico16. However, unlike Borensztein et al. (2001) theauthors did not control for exchange rate movements, thereby biasing the interest rate effectupwards. A possible explanation for the lacking insulation flexible regimes provide regarding increases ininterest rate premia is a lack of credibility, typically associated with flexible regimes, whichoffsets the increased flexibility and independence advantages flexible regimes initially possess(Calvo and Reinhart, 2002). In countries where expectations about future inflation and exchangerate development are volatile and uncertain, interest rates are likely to be high and volatile. Riskpremium shocks will unleash fears of devaluation and default, which typically will be greaterunder a flexible regime (that lacks credibility) than under a fixed regime, forcing a greateradjustment of domestic interest rates and thereby possibly explaining the higher variance ofinterest rates to risk premium shocks in some floating emerging markets. Indeed, reviewing the 3emerging market floaters Singapore, Chile and Mexico documented in Borensztein et al. (2001),the 2 economies that displayed increased monetary independence, Singapore and Chile, had lowlevels of inflation, while Mexico did not. Figure 5: Inflation in Mexico, Chile and Singapore 40% 30% However, focusing solely on 20% domestic interest rate movements can underestimate 10% the actual degree of monetary 0% independence, as high interest 92 93 94 95 96 97 98 99 00 Chile Mexico Singapore rate sensitivity could be caused source: IMF WEO database by similar business cyclesand/or similar shocks. Capital controls also play a decisive role as they increase monetaryautonomy under fixed exchange rates. Fear of floating also limits monetary autonomy aseconomies deliberately decide to limit exchange rate variability by using the interest rate as aninstrument for this purpose (Frankel et al., 2002). However, floating regimes under inflationtargeting use interest rates as a policy instrument, and therefore it is very difficult to quantifytheir actual amount of monetary independence (Calvo and Reinhart, 2002). Although the empirical evidence is mixed and measuring the amount of monetaryindependence an individual country possesses is a difficult and complicated procedure, a16 Hausmann et al. (1999, 12) find that a 1% increase in foreign interest rates leads to a 1.45% increase inArgentina and a 5.93% increase in Mexico. 30

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