Lecture 20: Exchange Rate Regimes Prof.J.Frankel

What exchange rate regimes do countries choose? Classification of exchange rate regimes What regimes should countries choose? 2. Advantages of fixed rates Advantages of floating rates How should the choice be made? Performance by category Traditional criteria for choosing: OCA framework Further criteria to suit a country for institutionally fixed rate Financial development Commodity price volatility and other trade/supply shocks. Appendices: I. Fashions in international currency policy II. The corners hypothesis III. De facto classification of countries’ regimes Prof.J.Frankel

1. Classification of exchange rate regime Continuum 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 Prof.J.Frankel

Trends in distribution of EM exchange rate regimes 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. Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011 (percent of total) } Ghosh, Ostry & Qureshi, 2014, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF. Prof.J.Frankel

2. Advantages of fixed rates Encourage trade <= lower exchange risk. In theory, can hedge risk. But costs of hedging: transactions costs, missing markets, and risk premia. Empirical: Exchange rate volatility ↑ => trade ↓ ? Shows up in: - Cross-section evidence, especially small & less developed countries. - Borders, e.g., Canada-US: McCallum-Helliwell (1995-98); Engel-Rogers (1996). - Currency unions: Rose (2000). Prof.J.Frankel

Advantages of fixed rates, cont. 2) Encourage investment 3) Provide nominal anchor for monetary policy By anchoring inflation expectations, achieve lower inflation for same Y. But which anchor? Exchange rate target vs. alternatives. 4) Avoid competitive depreciation “Currency Wars”. 5) Avoid speculative bubbles that can afflict floating. Prof.J.Frankel

3. Advantages of floating rates 1) Monetary independence. 2) Automatic adjustment to trade shocks. 3) Central bank retains seignorage. 4) Central bank retains Lender of Last Resort capability, for rescuing banks. 5) Avoiding crashes that hit pegged rates. Prof.J.Frankel

4. Which dominate: advantages of fixing or advantages of floating? Empirical studies of performance by category are inconclusive. See Appendix III, last slide. Why? No one exchange rate regime is right for all countries. The answer depends on a country’s circumstances. Traditional criteria for choosing: Optimum Currency Area. Prof.J.Frankel

Optimum Currency Area (OCA) Broad definition: An optimum currency area is a region (not necessarily coinciding with one country’s borders) that should have its own currency & own monetary policy. This definition can be given more content: An OCA can be defined as a region that is neither so small and open that it would be better off linking to the currency of a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies. Professor Jeffrey Frankel Prof.J.Frankel 9

Optimum Currency Area criteria for fixing exchange rate: Small size and openness because then advantages of fixing are large. Symmetry of shocks because then giving up monetary independence is a small loss. Labor mobility because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue. Fiscal transfers in a federal system because then consumption is cushioned in a downturn. Professor Jeffrey Frankel Prof.J.Frankel 10

New popularity in 1990s of institutionally-fixed corner currency boards (e.g., Hong Kong 1983- ; Lithuania 1994-2014; Argentina 1991-2001; Bulgaria 1997- ; Estonia 1992-2011; Bosnia 1998- ; Timor, 2000-…) dollarization (e.g., Panama, El Salvador, Ecuador; or euro-ization: Montenegro) monetary union (e.g., the eurozone, 1999- ). Prof.J.Frankel

Currency boards Definition: A currency board is a monetary institution that only issues currency fully backed by foreign assets. Its principal attributes include the following: An exchange rate that is fixed not just by policy, but by law. A reserve requirement stipulating that each dollar’s work of domestic currency is backed by a dollar’s worth of foreign reserves. A self-correcting balance of payments mechanism, in which a payments deficit automatically contracts the money supply, resulting in a contraction of spending. Prof.J.Frankel

1990’s criteria for the firm-fix corner suiting candidates for currency board or union (e.g., Calvo) Regarding credibility: a desperate need to import monetary stability, due to: history of hyperinflation, absence of credible public institutions, location in a dangerous neighborhood, or large exposure to nervous international investors; a desire for integration with a particular neighbor/ trading partner. Regarding other “initial conditions”: an already-high level of private dollarization high pass-through to import prices access to an adequate level of reserves. Prof.J.Frankel

(i) Level of financial development Two additional considerations, particularly relevant to developing countries (i) Level of financial development (ii) Prevalence of real shocks Professor Jeffrey Frankel Prof.J.Frankel

(i) Level of financial development Fixed rates are better for countries at low levels of financial development: because markets are thin. When financial markets develop, exchange flexibility becomes more attractive. Prof.J.Frankel

(ii) Real Shocks Textbook wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); floating rates work best if shocks tend to be real shocks (especially external trade shocks). One case of supply shocks: natural disasters Most common case of real shocks: trade Prof.J.Frankel 16

Terms-of-trade variability Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008, and again in 2011. => Favorable terms of trade shocks for some (Africa, Latin America, & other oil exporters); => Unfavorable terms of trade shock for others (oil importers like Japan, Korea, India, Turkey). Commodity prices fell in 2014-15. A country where trade shocks dominate should accommodate by floating. Prof.J.Frankel

End of Lecture 21: Exchange Rate Regimes Prof.J.Frankel

Appendix I: 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 (either firm fix or float) 1998-2007: Inflation Targeting became the new conventional wisdom. 2008-: IT lost some of its attractiveness in the Global Financial Crisis, due to its neglect of asset prices. IT Prof.J.Frankel 19

Appendix II: The corners hypothesis The claim: “Countries can either rigidly peg or freely float, but should abandon intermediate regimes like target zones.” Origins: 1992-93 ERM crises -- Eichengreen (1994) Late-1990’s crises in emerging markets Prof.J.Frankel

Intermediate regimes target zone (band) Krugman-ERM type (with nominal anchor) Bergsten-Williamson type (FEER adjusted automatically) basket peg (weights can be either transparent or secret) crawling peg pre-announced (e.g., tablita) indexed (to fix real exchange rate) adjustable peg (escape clause, e.g., contingent on terms of trade or reserve loss) Prof.J.Frankel

The rise & fall of the Corners Hypothesis It became fashionable in the late 1990s. But: Since Argentina’s 2001 crisis forced it to abandon its “convertibility plan,” currency boards and the corners hypothesis have lost popularity. The intermediate regimes are alive and well. The dominant long-term trend is, rather, toward flexibility. Prof.J.Frankel

Appendix III: De facto classification of regimes De jure regime  de facto Many countries that say they float, in fact intervene heavily in the foreign exchange market. [1] Many countries that say they fix, in fact devalue when trouble arises. [2] Many countries that say they target a basket of major currencies in fact fiddle with the weights. [3] [1] “Fear of floating” -- Calvo & Reinhart (2001, 2002); Reinhart (2000). [2] “The mirage of fixed exchange rates” -- Obstfeld & Rogoff (1995). [3] Parameters kept secret -- Frankel, Schmukler & Servén (2000). Prof.J.Frankel

A number of studies have classified countries by de facto exchange rate regimes. But their designations are not highly correlated with each other. Andrew Rose, 2011, "Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky,” J. Ec. Literature, Vol. 49, No. 3, Sept., pp. 652-672. Prof.J.Frankel

Which exchange rate regimes show higher growth on average Which exchange rate regimes show higher growth on average? Different classification schemes give different results. Growth Effects of Deviations from Fixed Exchange Rate Regimes IMF classification => crawls do best R&R classification => floats do best LY&S classification => fixed rates do best. Andrew Rose, 2011, "Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky,” Journal of Economic Literature, Vol. 49, No. 3, Sept., pp. 652-672. Table 2. Prof.J.Frankel