Lectures 19-20:

Exchange Rate Regimes

Professor Jeffrey Frankel

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.

VI. Intermediate regimes & the corners hypothesis

Appendix: An alternative for commodity-exporting countries.

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

Trends in distribution of EM exchange rate regimes

Ghosh, Ostry & Qureshi, 2015, IMF Economic Review, “Exchange Rate Management and Crisis Susceptibility: A Reassessment”

Distribution of Exchange Rate Regimes in Emerging Markets 3-category classification (IMF’s de jure), 1980-2011, percent of total

• 1973-1985 – Many abandoned fixed exchange rates • 1986-94 – Exchange rate-based stabilization programs • 1990s -- Corners Hypothesis: countries move to either hard peg or free float • Since 2001 -- The rise of the “managed float” category.

} Trends in distribution of EM exchange rate regimes, continued

Finer classification (IMF’s de jure). 1980-2011, percent of total

(currency board or no

separate legal tender)

Ghosh, Ostry & Qureshi, (2015)

• Many countries that say they float, in fact intervene heavily in the foreign exchange market. [1]

• Many countries that say they fix, in fact devalue when trouble arises. [2]

• Many countries that say they target a basket of major currencies in fact fiddle with the weights. [3]

[1] “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000).

[2] “The mirage of fixed exchange rates” -- Obstfeld & Rogoff (1995).

[3] Parameters kept secret -- Frankel, Schmukler & Servén (2000).

De jure regime de facto

One statistical approach to ascertaining de facto regimes:

Var (exchange rate) vs. Var (reserves).

• Calvo & Reinhart (2002) note that many countries that de jure say they float in fact have a lower Var (Δe) relative to Var (ΔRes) than many that say they fix !

• Levy-Yeyati & Sturzenegger (2005)

classify all countries based on variability of Δe vs. variability of ΔRes.

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 !

The de facto classification schemes tend to agree with each other even less than they agree with the de jure scheme!

Percentage agreement of methodologies to code who pegs

De

Jure Jay S. LY-S R-R

De

Jure 100%

Jay S.

86% 100%

LY-S

74% 80% 100%

R-R

81% 82% 73% 100%

Jay Shambaugh (2007)

De Jure: IMF. LY-S: Levy-Yeyati & Sturzenegger. R-R: Reinhart & Rogoff

Professor Jeffrey Frankel

II. Advantages of fixed rates

1) Encourage trade <= lower exchange risk.

• True, in theory, one 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.

- Currency unions: Rose (2000).

The Rose finding

• Rose (2000) -- the boost to bilateral trade from currency unions is: – significant, – ≈ FTAs, & – larger (2- or 3-fold) than had been previously thought.

• Many others have advanced critiques. (Survey: Baldwin, 2006.)

– Re: sheer magnitude • endogeneity, • small countries, • missing variables.

– Estimated magnitudes are often smaller, • e.g., trade effect of euro has been at most 50%. (Glick & Rose, 2016) • but the finding that CU effect is as large as FTA effect

has withstood perturbations and replications well.

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 dynamically-consistent inflation-fighting.

• But which anchor? Exchange rate target vs. alternatives

4) Avoid competitive depreciation (“currency wars”)

5) Avoid speculative bubbles that afflict floating. (versus: if variability is from fundamental real exchange rate shocks,

it will just pop up in prices instead of nominal exchange rates).

Professor Jeffrey Frankel

III. Advantages of floating rates

1. Monetary independence

2. Automatic adjustment to trade shocks

3. Retain seigniorage

4. Retain Lender of Last Resort ability

5. Avoiding crashes that hit pegged rates. (This is an advantage especially if origin of speculative attacks is multiple equilibria, not fundamentals.)

Advantage of monetary independence: Foreign interest rates have a negative impact on GDP in pegged countries; flexible exchange rates do insulate according to this study.

The effects of US (or other base country) interest rate R on real output growth:

1 2 3 4 Full sample Nonpegs Pegs Full sample

Base R − 0.046 0.046 − 0.137** 0.046 0.032 0.039 0.044 0.039

Base R × Peg − 0.183**

0.055

Peg 0.014**

0.004

Constant 0.036** 0.030** 0.043** 0.030** 0.002 0.003 0.003 0.003

Observations 3831 2078 1753 3831

** Significant at 1%. Robust standard errors clustered at country level Sample: 1973-2002.

di Giovanni & Shambaugh (2008), "The impact of foreign interest rates on the economy: The role of the exchange rate regime," JIE. di Giovanni & Shambaugh (2008), "The impact of foreign interest rates on the economy: The role of the exchange rate regime," JIE.

Professor Jeffrey Frankel

IV. Which dominate: advantages of fixing or advantages of floating?

Performance by category is inconclusive.

• To over-simplify findings of 3 studies: – Ghosh, Gulde & Wolf: hard pegs work best

– Sturzenegger & Levy-Yeyati: floats perform best

– Reinhart-Rogoff: limited flexibility is best !

• Why the different answers? – The de facto schemes do not correspond to each other.

– Conditioning factors (beyond rich vs. poor).

Which dominate: advantages of fixing or advantages of floating?

Answer depends on circumstances, of course:

No one exchange rate regime is right for 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.

Professor Jeffrey Frankel

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 & open that it would be better off pegging its currency to a neighbor, nor so large & heterogenious that it would be better off splitting into sub-regions with different currencies.

Professor Jeffrey Frankel

Optimum Currency Area criteria for giving up currency independence:

• 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

The endogeneity of the OCA criteria

Endogeneity of OCA criteria:

• Bilateral trade responds positively to currency union -- Rose (2000).

• A country pair’s cyclical correlation rises too.

• Implication: members of a monetary union may meet OCA criteria better ex post than ex ante -- Frankel & Rose (1996).

Popularity in 1990s of institutionally-fixed corner

• currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994-2015;

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

Regarding credibility:

Regarding other “initial conditions”: • an already-high level of private dollarization

• high pass-through to import prices

• access to an adequate level of reserves.

• 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

V. Three additional considerations, particularly relevant to developing countries

• (i) Emigrants’ remittances

• (ii) Level of financial development

• (iii) Supply shocks and

external terms of trade shocks

I would like to add to the traditional OCA list:

Cyclically-stabilizing emigrants’ remittances.

• If country S has sent immigrants to country H, their remittances are correlated with the differential

in growth or employment in S versus H. (Frankel, 2011)

• This strengthens the case for S pegging to H.

• Why? It helps stabilize the current account even when S has given up ability to devalue.

(ii) Level of financial development

• Aghion, Bacchetta, Ranciere & Rogoff (2005)

– Fixed rates are better for countries at low levels of financial development: markets are thin.

– When financial markets develop, exchange flexibility becomes more attractive. • Estimated threshold: Private Credit/GDP > 40%.

• Husain, Mody & Rogoff (2005)

For richer & more financially developed countries, flexible rates work better

– in the sense of being more durable

– & delivering higher growth without inflation.

(iii) External Shocks

Old textbook wisdom regarding 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.

For a country subject to big terms of trade shocks

the exchange rate should be able to accommodate them.

When the $ price

of commodities is:

we want the

currency to

high, appreciate

so as to avoid

excessive money inflows, credit,

debt, inflation & asset bubbles.

When the $ price

of commodities is:

we want the

currency to

so as to avoid

high, appreciate excessive money inflows, credit,

debt, inflation & asset bubbles.

low, depreciate trade deficit, fx reserve crisis,

excessively tight money & recession.

Should commodity exporters float?

• Of course some will continue to fix the exchange rate, – especially very small countries.

• But others need some degree of exchange rate flexibility.

• The long-time conventional wisdom that floating works better, for countries exposed to volatility in the prices of their export commodities, has been confirmed in empirical studies, including: – Broda (2004), – Edwards & Levy-Yeyati (2005), – Rafiq (2011), – and Céspedes & Velasco (2012).

28

** Statistically significant at 5% level.

Constant term

not reported.

(t-statistics in parentheses.)

Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity price

change & the smaller is exchange rate flexibility.

Céspedes & Velasco, 2012, IMF Economic Review “Macroeconomic Performance During Commodity Price Booms & Busts”

• Is full discretion an option? – The Fed & some other major central banks, for now,

have given up on attempts to communicate intentions in terms of a single variable, • even via forward guidance, let alone an explicit target (like IT).

• But the presumption is still in favor of transparency and clear communication.

• Many still feel the need to announce a simple target.

– Most developing countries, in particular, – need the reinforcement to credibility.

But if the exchange rate is not to be the nominal anchor for monetary policy, then what is?

Monetary policy-makers in developing countries may have more need for credibility.

a) due to high-inflation histories, b) less-credible institutions, or c) political pressure to monetize big budget deficits.

A. Fraga, I. Goldfajn & A. Minella (2003), “Inflation Targeting in Emerging Market Economies.”

But it does not add to credibility to announce a target which the central bank is likely to miss subsequently.

Solution for commodity exporters? See Appendix.

VI. Intermediate exchange rate regimes

and the corners hypothesis

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)

Origins: • 1992-93 ERM crises -- Eichengreen (1994)

• Late-90’s crises in emerging markets – Fischer (2001).

But the pendulum swung back,

• from 61% of IMF staff in 2002, to 0% in 2010. • Many developing countries follow intermediate exchange rate regimes. • The theoretical rationale for the corners hypothesis never was clear.

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.

Managed float (“leaning against the wind”):

Kaushik Basu & Aristomene Varoudakis, Policy RWP 6469, World Bank, 2013, “How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14

Turkey’s central bank buys lira when it depreciates, and sells when it is appreciates.

In Latin America, renewed inflows in 2010

less-managed floating (“more appreciation-friendly”)

more-managed floating

Source: GS Global ECS Research

but as appreciation in Chile & Colombia. were reflected mostly as reserve accumulation in Peru,

Korea & Singapore in 2010 took renewed inflows mostly in the form of reserves,

Source: Goldman Sachs Global ECS Research Data from Haver Analytics and Bloomberg

less-managed floating (“more appreciation-friendly”)

more-managed floating

while India & Malaysia took them mostly in the form of currency appreciation.

Appendix

IT versus an alternative anchor to take into account

commodity product prices

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

Professor Jeffrey Frankel

6 proposed nominal targets and the Achilles heel of each:

Targeted

variable Vulnerability Example

Monetarist rule

M1 Velocity shocks US 1982

Inflation targeting CPI

Import price

shocks Oil shocks of

1973-80, 2000-08

Nominal income

targeting

Nominal

GDP

Measurement

problems

Less developed

countries

Gold standard Price

of gold

Vagaries of world

gold market

1849 boom;

1873-96 bust

Commodity

standard

Price of agric.

& mineral

basket

Shocks in

imported

commodity

Oil shocks of

1973-80, 2000-08

Fixed

exchange rate $

(or €)

Appreciation of $ (or € )

1995-2001

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.

Professor Jeffrey Frankel

• The shocks of 2008-2012 showed disadvantages to Inflation Targeting, – analogously to how the EM crises of the 1994-2001

showed 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.

What choice of monetary anchor or target?

• Of the variables that are candidates for nominal target,

• the traditional ones prevent accommodation of terms of trade shocks:

1. Not just exchange rate target,

2. but also M1 (traditional monetarism)

3. and the CPI (Inflation Targeting).

• But some novel candidates would facilitate accommodation of trade shocks:

4. Target an index of product prices (PPT)

5. Target Nominal GDP (NGDPT)

6. Add the export commodity to a currency basket peg (CCB).

New proposal: Target a Currency + Commodity Basket (CCB)

• Consider three commodity-exporters that, at times, have pegged to a basket of major foreign currencies: – Kuwaiti dinar (1975-2003, 2007-present), pegged to basket of $ + €,

– Chilean peso (1992-1999) pegged to $ + DM + ¥,

– Kazakh tenge (2013-2014) to $ + € + ₱.

• The proposal is to add the commodity to the basket. – E.g., oil for Kuwait & Kazakhstan,

– copper for Chile.

CCB: Add the export commodity to the currency basket

Target a Currency + Commodity Basket (CCB)

• This target would give the best of both worlds:

– Has the advantages of a nominal anchor

• Like a peg, it is precise and transparent on a daily basis,

– determined by observed daily price in London or ICE.

– while yet sustainable on a long-term basis:

• Like a float, the currency would automatically strengthen (vs. the $) when the $ price of oil rises,

• and automatically fall when the price of oil falls.

Professor Jeffrey Frankel

Does floating give the same answer?

• True, commodity currencies tend to appreciate when commodity markets are strong, & vice versa

– Australian, Canadian & NZ $ (e.g., Chen & Rogoff, 2003)

– South African rand (e.g., Frankel, 2007)

– Chilean peso and others

• But

– Some volatility under floating appears gratuitous.

– Floaters still need a nominal anchor.

Professor Jeffrey Frankel

The Rand, 1984-2006: Fundamentals (real commodity prices,

real interest differential, country risk premium, & l.e.v.) can explain the real appreciation of 2003-06 – Frankel (SAfrJEc, 2007).

0.000

20.000

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Q2 1984

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RERICPIactual RERICPIFitted RERICPIProjected

Actual vs Fitted vs. Fundamentals- Projected Values