Lectures 13-14: Exchange Rate Regimes

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 Appendices Professor Jeffrey Frankel 2

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 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, 2013, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF ARC , Nov..

De jure regime  de facto as is by now well-known Many countries that say they float, in fact intervene heavily in the foreign exchange market. [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).

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 !

Correlations Among Regime Classification Schemes GGW =Ghosh, Gulde & Wolf. LY-S = Levy-Yeyati & Sturzenegger. R-R = Reinhart & Rogoff Sample: 47 countries. From Frankel, ADB, 2004. Table 3, prepared by M. Halac & S.Schmukler. Professor Jeffrey Frankel

II. Advantages of fixed rates Encourage trade <= lower exchange risk. True, in theory, can hedge risk. But costs of hedging: missing markets, transactions costs, and risk premia. Empirical: Exchange rate volatility ↑ => trade ↓ ? Time-series evidence showed little effect. But more in: - Cross-section evidence, especially small & less developed countries. - Currency unions: Rose (2000). Professor Jeffrey Frankel

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 of Rose research. Re: sheer magnitude endogeneity, small countries, missing variables. Estimated magnitudes are often smaller, but the basic finding has withstood perturbations and replications remarkably well. ii/ Some developing countries seeking regional integration talk of following Europe’s lead, though plans merit skepticism. [ii] E.g., Rose & van Wincoop (2001); Tenreyro & Barro (2003). Survey: Baldwin (2006)

Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 3) Provide nominal anchor for monetary policy Barro-Gordon model of time-consistent inflation-fighting But which anchor? Exchange rate target vs. Alternatives 4) Avoid competitive depreciation (“currency wars”) 5) Avoid speculative bubbles that afflict floating. (vs. if variability is fundamental real exchange rate risk, it will just pop up in prices instead of nominal exchange rates).

III. Advantages of floating rates Monetary independence Automatic adjustment to trade shocks Retain seigniorage Retain Lender of Last Resort ability Avoiding crashes that hit pegged rates. (This is an advantage especially if origin of speculative attacks is multiple equilibria, not fundamentals.) Professor Jeffrey Frankel 12

IV. Which dominate: advantages of fixing or advantages of floating 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, e.g., rich vs. poor). Professor Jeffrey Frankel 13

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.

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 15

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 16

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 (rather than falling, as under Eichengreen-Krugman hypothesis). Implication: members of a monetary union may meet OCA criteria better ex post than ex ante -- Frankel & Rose (1996). Professor Jeffrey Frankel 17

Popularity in 1990s of institutionally-fixed corner currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992-2011; Bosnia, 1998- ; …) dollarization (e.g, Panama, El Salvador, Ecuador) monetary union (e.g., EMU, 1999)

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

V. Three additional considerations, particularly relevant to developing countries (i) Emigrants’ remittances (ii) Level of financial development (iii) Supply shocks and external terms of trade shocks

This strengthens the case for S pegging to H. I would like to add to the traditional OCA list: Cyclically-stabilizing emigrants’ remittances. If country S has sent immigrants to country H, are their remittances correlated with the differential in growth or employment in S versus H? Apparently yes. (Frankel, “Are Bilateral Remittances Countercyclical?” 2011) This strengthens the case for S pegging to H. Why? It helps stabilize 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. 22

(iii) External Shocks An old wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks -- especially monetary; floating rates work best if shocks tend to be real shocks -- especially external terms of trade. 23

Terms-of-trade variability Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, such as Mideast, Africa, Latin America); => Unfavorable terms of trade shock for others (oil importers such as Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating. Confirmed empirically: Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates. Broda (2004), Edwards & L.Yeyati (2005), Rafiq (2011), and Céspedes & Velasco (2012) 24

Across 107 major commodity boom-bust cycles, Céspedes & Velasco (Nov. 2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts” Constant term not reported. (t-statistics in parentheses.) ** Statistically significant at 5% level. Across 107 major commodity boom-bust cycles, output loss is bigger the bigger is the commodity price change & the smaller is exchange rate flexibility.

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)

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. 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.

Managed float (“leaning against the wind”): Turkey’s central bank buys lira when it depreciates, and sells when it is appreciates. 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

In Latin America, renewed inflows in 2010 were reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating less-managed floating (“more appreciation-friendly”) Source: GS Global ECS Research

Korea & Singapore in 2010 took renewed inflows mostly in the form of reserves, while India & Malaysia took them mostly in the form of currency appreciation. more-managed floating less-managed floating (“more appreciation-friendly”) Goldman Sachs Global ECS Research

The flexibility parameter can be estimated in terms of Exchange Market Pressure: Define Δ EMP = Δ value of currency + Δ reserves/MB. Δ EMP represents shocks in currency demand. Flexibility can be estimated as the propensity of the central bank to let shocks show up in the price of the currency (floating) , vs. the quantity of the currency (fixed), or in between (intermediate exchange rate regime).

Distillation of technique to infer flexibility When a shock raises international demand for the currency, does it show up as an appreciation, or as a rise in reserves? EMP variable appears on the RHS of the equation. The % rise in the value of the currency appears on the left. A coefficient of 0 on EMP signifies a fixed E (no changes in the value of the currency), a coefficient of 1 signifies a freely floating rate (no changes in reserves) and a coefficient somewhere in between indicates a correspondingly flexible/stable intermediate regime.

Appendix 2: Tables comparing economic performance of different regimes APPENDICES ON EXCHANGE RATE REGIMES Appendix 1: On the RMB Appendix 2: Tables comparing economic performance of different regimes Appendix 3: The econometrics of estimating de facto exchange rate regimes. Appendix 4: IT versus alternative anchors, with volatility in commodity export prices

Appendix 1 On the RMB

Five reasons why China should move to a more flexible exchange rate regime, in its own interest Overheating of economy 2007: stock market bubble, bottlenecks, inflation 6%, price controls (Sept. 2007). 2008-09 slowdown: loss of demand Back by 2010-11. Excessive reserves (≈ $4 trillion) though a useful shield against currency crises, China has enough reserves. Harder to sterilize the inflow over time. Attaining internal and external balance. To attain both, need 2 policy instruments. In a large country like China, the expenditure-switching policy should be the exchange rate. Along with expenditure-increasing policies (2009). Avoiding crisis: Experience suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. RMB undervalued, judged by Balassa-Samuelson criterion.

Excgange rate E in RMB/$ China was back in the overheating + surplus quadrant of the Swan Diagram by 2010 Excgange rate E in RMB/$ YY: Internal balance Y = 𝑌 ED & TD ES & TD ES & TB>0 China 2010 BB: External balance CA=0 2002 ED & TB>0 Spending A

How should changes in real exchange rate, when necessary, be achieved? For a very small, open economy advantages of keeping E fixed are large. Adjustment may take place via prices instead Example: Hong Kong. For a large economy like China, it makes more sense to adjust E than to adjust prices

What would new regime be? No need for pure float. China is an example of why the Corners Hypothesis is wrong Band or target zone may be best With what as anchor? Advantage of dollar: simple and transparent Advantage of basket: better diversification Asia currently lacks a good anchor currency.

Tables comparing economic performance of different regimes: Appendix 2 Tables comparing economic performance of different regimes: Ghosh, Gulde & Wolf Sturzenegger & Levy-Yeyati Reinhart & Rogoff

Which category experienced the most rapid growth? Ghosh, Gulde & Wolf: currency boards Levy-Yeyati & Sturzenegger: floating Reinhart & Rogoff: limited flexibility

Levy-Yeyati & Sturzenegger (2001): floats work best.

Effect of regime on growth rates, controlling for various determinants Levy-Yeyati & Sturzenegger (2001). Sample: yearly observations 1974-1999.

Appendix 3: The econometrics of estimating de facto exchange rate regimes. Why do the various schemes for classifying countries by de facto exchange rate regimes give such different answers? Synthesis of the technique for estimating the anchor and the technique for estimating the degree of exchange rate flexibility.

Schemes for de facto classification have themselves been divided into two classifications, viewed as: “mixed de jure-de facto classifications, because the self-declared regimes are adjusted by the devisers for anomalies.” Vs. “pure de facto classifications because…assignment of regimes is based solely on statistical algorithms….” -- Tavlas, Dellas & Stockman (2006).

Jay Shambaugh (2007) again finds that the de facto classification schemes tend to agree with each other even less than they agree with the de jure scheme. Professor Jeffrey Frankel

As do Bénassy-Quéré et al (2004) The IMF now has its own “de facto classification” -- but still close to official IMF one: correlation (BOR, IMF) = .76

Pure de facto classification schemes Method to estimate degree of flexibility: Levy-Yeyati & Sturzenegger (2005): compare variability of Δ exchange rates vs. variability of Δ reserves. 2. Method to estimate implicit basket weights: Regress Δ value of local currency against Δ values of major currencies. Frankel & Wei (1993, 95, 2007), Bénassy-Quéré (1999), B-Q et al (2004). Close fit => a peg. Coefficient of 1 on $ => $ peg. Or on other currencies => basket peg. Example of China, post 7/2005. 3. Synthesis method: F & Wei (2008), F & Xie (2010) . Regress Δ value of local currency against EMP, to estimate flexibility parameter and against Δ values of $ and other major currencies, to estimate weights in anchor basket.

IT versus alternative anchors Appendix 4 IT versus alternative anchors to take into account commodity export product prices

Fashions in international currency policy 1980-82: Monetarism (target the money supply) 1984-1997: Fixed exchange rates (incl. currency boards) 1993-2001: The corners hypothesis 1998-2008: Inflation targeting (+ currency float) became the new conventional wisdom Among academic economists among central bankers and at the IMF IT Professor Jeffrey Frankel 51

6 proposed nominal targets and the Achilles heel of each: IT Professor Jeffrey Frankel 52

Inflation Targeting has been the reigning orthodoxy. IT Inflation Targeting has been the reigning orthodoxy. Flexible inflation targeting ≡ “Have a LR target for inflation, and be transparent.” Who could disagree? But define IT as setting yearly CPI targets, to the exclusion of asset prices exchange rates export commodity prices. Some reexamination is warranted, in light of 2008-2011. Professor Jeffrey Frankel 53

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. IT Professor Jeffrey Frankel 54

Proposal for Product Price Targeting PPT Intended for countries with volatile terms of trade, e.g., those specialized in commodities. The authorities stabilize the currency in terms of an index of product prices, such as the GDP deflator, (a basket that gives weight to prices of its commodity exports), rather than to the CPI (which gives weight to imports). The regime combines the best of both worlds: The advantage of automatic accommodation to terms of trade shocks, together with the advantages of a nominal anchor. 55 55

Why is PPT better than CPI-targeting for countries with volatile terms of trade? Better response to adverse terms of trade shocks: If the $ price of the export commodity goes up, PPT says to tighten monetary policy enough to appreciate currency. Right response. (E.g., Gulf currencies in 2007-08.) If the $ price of imported commodity goes up, CPI target says to tighten monetary policy enough to appreciate currency. Wrong response. (E.g., oil-importers in 2007-08.) => CPI targeting gets it backwards. Professor Jeffrey Frankel 56

Recap of Product Price Targeting: PPT Recap of Product Price Targeting: Target an index of domestic production prices. [1] The important point: include export commodities in the index and exclude import commodities, whereas the CPI does it the other way around. [1] Frankel (2011). Professor Jeffrey Frankel 57 57

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 58

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 (SAJE, 2007). Actual vs Fitted vs. Fundamentals- Projected Values Professor Jeffrey Frankel 59

In practice, most IT proponents agree central banks should not tighten to offset oil price shocks They want focus on core CPI, excluding food & energy. But food & energy ≠ all supply shocks. Use of core CPI sacrifices some credibility: If core CPI is the explicit goal ex ante, the public feels confused. If it is an excuse for missing targets ex post, the public feels tricked. The threat to credibility is especially strong where there are historical grounds for believing that government officials fiddle with the CPI for political purposes. Perhaps for that reason, IT central banks apparently do respond to oil shocks by tightening/appreciating….