Lecture 21: Exchange Rate Regimes

1. Lecture 21: Exchange Rate Regimes Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

2. What are countries doing? • Classification of exchange rate regimes • De jure vs. De facto • What should countries be doing? • Advantages of fixed rates • Advantages of floating rates • How should the choice be made? • Performance by category • Traditional criteria for choosing: OCA framework • 1990s criteria to suit a country for institutionally fixed rate • Financial development • External shocks: Commodity price volatility. • Addenda:Attempts to classify countries’ regimes, & performance • The corners hypothesis Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

3. 1. Classification of exchange rate regimeContinuum 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 Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

4. 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) Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

5. 2. 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).

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

7. Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 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 5) Avoid speculative bubbles that afflict floating. (If variability were all from fundamental real exchange rate risk, and no bubbles, then fixing the nominal exchange rate would mean it would just pop up in prices instead.) Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

8. 4. Advantages of floating rates • Monetary independence • Automatic adjustment to trade shocks • Central bank retains seignorage • Central bank retains Lender of Last Resort capability, for rescuing banks • Avoiding crashes that hit pegged rates, • particularly if origin of speculative attacks is multiple equilibria, not fundamentals. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

9. 5. Which dominate: advantages of fixing or advantages of floating?Performance by category is inconclusive. • To over-simplify 3 important studies (see Addendum I): • Ghosh, Gulde & Wolf: “hard pegs work best” • Sturzenegger & Levy-Yeyati: “floats are best” • Reinhart-Rogoff: “limited flexibility performs best” • Why the different answers? • The de facto schemes do not correspond to each other. • A country’s circumstances determine the appropriate regime. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

10. Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances: No one exchange rate regime is rightfor all countries or all times. • Traditional criteria for choosing - Optimum Currency Area.Focus is on trade and stabilization of business cycle. • 1990s criteria for choosing –Focus is on financial markets and stabilization of speculation. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

11. Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency and own monetary policy. This definition can be given more content: An OCA can be defined as: a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies Professor Jeffrey Frankel

12. 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

13. New popularity in 1990s ofinstitutionally-fixed corner • currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992- ; Bosnia, 1998- ; …) • dollarization (e.g, Panama, El Salvador, Ecuador; or euro-ization: Montenegro) • monetary union (e.g., EMU, 1999) Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

14. Currency boards • Definition: A currency board is a monetary institution that only issues currency that is 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. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

15. 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. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

16. Two additional considerations, particularly relevant to developing countries (i) Level of financial development (ii) Supply shocks, especially: External terms of trade shocksand the proposal for Product Price Targeting PPT Professor Jeffrey Frankel

17. (i) Level of financial development Aghion, Bacchetta, Ranciere & Rogoff (2005) • 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. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

18. (ii) External Shocks An old wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); floating rates work best if shocks tend to be real shocks (especially external terms of trade). One case of supply shocks: natural disasters R.Ramcharan (2007) finds support. Most common case of real shocks: trade Professor Jeffrey Frankel

19. Terms-of-trade variability returns • 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 (oil producers, Africa, Chile, etc.); • => Unfavorable terms of trade shock for others (oil importers like Japan, Korea). • Textbook theory says a country where trade shocks dominate should accommodate by floating. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

20. 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 1998-2007: Inflation targeting (+ currency float) became the new conventional wisdom. 2008-09: IT lost some of its attractiveness in the Global Financial Crisis, due to its neglect of asset prices. IT Professor Jeffrey Frankel

21. Addendum I:Schemes for de facto classification • have been divided into two categories, by Tavlas, Dellas & Stockman (2008), • “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….” Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

22. Of 185 Fund members, Have given up own currencies: Euro-zone: CFA Franc Zone: E.Caribbean CA “dollarized” Currency boards: Intermediate regimes: pegs to a single currency pegs to a composite crawling pegs horizontal bands crawling bands managed floats “independent floaters”: (end-2004 “de facto”) 41 12 14 6 97 104 33 8 6 5 1 51 35 IMF classification

23. Adjusted de jure classification schemes • Ghosh, Gulde, Ostry & Wolf (1995) identify “peggers” who in fact devalue often. • Bubula & Otker-Robe (2002) adjust by consulting IMF economists. • Reinhart & Rogoff (2003, 04) add category of “free falling”. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

24. De facto classification schemes • Shambaugh (2004): variability of exchange rate. • Levy-Yeyati & Sturzenegger (2005): cluster analysis based on variability of Δ exchange rates vs. variability of Δ reserves • Implicit basket weights method: regress Δvalue of local currency against Δ values of major currencies. Frankel & Wei (1993, 2007), Bénassy-Quéré (1999), B-Q et al (2004). • Close fit => a peg. • Coefficient of 1 on $ => $ peg. • Or other currencies => basket peg. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

25. 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 ! Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

26. Correlations Among Regime Classification Schemes Sample: 47 countries. From Frankel, “Experience of and Lessons from Exchange Rate Regimes in Emerging Economies,” ADB, 2004. Table 3, prepared by Marina Halac & Sergio Schmukler. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

27. Three studies of how well exchange rate regimes perform give different answers. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

28. Addendum II: The corners hypothesis • The claim: • “Countries can 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 • 1994 Mexico • 1997 Thailand, Korea • 1998 Russia; Brazil • 2001 Turkey Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

29. 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. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

30. What is the rationale for the corners hypothesis? • The Impossible Trinity? (Fischer,2001) • No; Intermediate regimes are theoretically compatible with high capital mobility. • Procrastination? Governments politically postpone exit. • (Mexico 1994 & Thailand 1997) => bad outcomes. (Willett, 2006) • Moral hazard of forex reserves?(Dooley)But high reserves, empirically, reduce speculative attacks. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

31. Possible rationales for the corners hypothesis,cont. • To discourage mismatch (unhedged $ liabilities, Hausmann’s “original sin”), even if it reduces capital inflow? (Eichengreen) • Perhaps floating can shift debt-denomination to local currency, producing the good equilibrium after all (no currency mis-match). • Since 2003, it seems to have worked: more emerging market recipients of large inflows this decade now have floating exchange rates and local-denominated debt. • The exceptions, like Hungary, got into big trouble in 2008 Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

32. Or perhaps “the grass always looks greener” in the corners of the pasture. • The pendulum has swung back: • Especially after failure of Argentina’s currency board (okay, “convertibility plan”) & 2001 collapse • Surely an intermediate regime (BBC) is the right answer for China now. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University

33. Bottom line on corners hypothesis: • Don’t cling to overvalued pegs. • But don’t blame the exchange rate regime for symptoms of other problems. Professor Jeffrey Frankel – Kennedy School of Government – Harvard University