Exchange Rate Regimes and the Stability of the International Monetary System *

1. Exchange Rate Regimes and the Stability of the International Monetary System* Jonathan D. Ostry and Atish R. GhoshResearch Department, IMFStockholm Institute of Transition EconomicsApril 8, 2010 * The views expressed in this presentation are those of the authors and do not necessarily represent those of the IMF or IMF policy. Based on IMF Occasional Paper No. 270 (Ghosh, Ostry, and Tsangarides (2010)).

2. Context • The current crisis has reopened some perennial issues: • Role of exchange rate regimes, including in relation to global imbalances • Medium-term stability of the International Monetary System (IMS) • The picture • Countries with pegged regimes accumulating large reserves stockpiled in U.S. dollars • Reserve currency issuers facing runaway deficits and debt? • Expression of concern on U.S. dollar’s role from key players (Zhou (PBC), 2009; UN (Stiglitz) 2009) • Open questions • Will floats be more attractive for EMEs post-crisis? • Or will the crisis lead to more demand of self insurance?

3. Stability of IMS a key mandate of the IMF • Member countries and the IMF should collaborate to: “assure orderly exchange arrangements and promote a stable system of exchange rates” (Article IV, Section 1.) • Essential purpose of the international monetary system (from Articles): • Facilitates the exchange of goods, services and capital • Sustains sound economic growth with reasonable price stability • Avoids erratic disruptions • Interpretation: three dimensions of systemic stability • Achieves individual country’s domestic macroeconomic goals • Facilitates the country’s interaction with the rest of the system • Results in a stable global system—role of systemic countries

4. What is new here? Exchange rate regime choice • Now, more nuanced message compared to previous IMF reviews • Pegs and intermediates: • Lower inflation without compromising growth • Higher trade and “stabilizing” capital flows • Floats • Lower susceptibility to currency and financial crises • Smother external adjustment • No universally “right” exchange rate regime • Previous IMF reviews • “Exchange Rate Regimes in an Increasingly Integrated World Economy” (1999) • Bipolar view: hard pegs or pure floats • “Evolution and Performance of Exchange Rate Regimes” (2003) • EMEs should move towards greater flexibility • Reasons for differences • Genuine benefits of pegs • De jure/de facto/richer dataset

5. What is new? Systemic issues • Potential risks to the system • Scramble for reserves • Rapidly rising accumulation in EMEs • Is greater risk of contagion from AM a reason to self insure more, or to float? • Increasing global imbalances • Narrowed during crisis but could widen if sources of growth in U.S. and Asia don’t change • Reserve currency status of the U.S. dollar • Do concentrated official holdings of dollar assets increase or decrease risk of sudden tipping point? • How to manage risks? • IMF instruments as alternative to self insurance • Reduce global imbalances by • More exchange rate flexibility in key surplus economies • Peer pressure/monitoring of full gamut of economic policies (multilateral consultation) • Managing risks of tipping point • Multi-currency system/SDRs • Substitution account, etc?

6. Presentation plan • Trends in regime choice, defining the regime • Macroeconomic performance • Monetary and fiscal policies • Inflation, growth, trade • Systemic interactions • Susceptibility to crises • External adjustment • Systemic risks • Reserve accumulation • Global imbalances • Reserve currency status of the dollar • Key findings

7. Exchange Rate Regime and Macro Performance

8. Overall trends in regime choice, full sample

9. Trends in emerging markets…

10. Trends in emerging markets…

11. Trends in developing countries…

12. Trends in developing countries…

13. Fiscal policy more flexible in floats

14. Monetary policy more flexible in floats

15. Inflation, simple averages

16. Inflation, controlling for other factors *** *** ***

17. Inflation, with controls, various groups

18. Inflation, with controls, other samples *** *** *** *** *** *** *** ***

19. Output growth per capita, simple averages

20. Channels of indirect association between regime and output growth Intermediate regimes are associated with lower RER overvaluation, lower price and RER volatility, lower inflation, and higher openness vis-à-vis floats. 19

21. Output growth, with controls* *** * *Regression of per capita output growth on regime dummies and other control variables. “Total effect” takes into account indirect channels through competitiveness, RER volatility, inflation, price volatility, and trade openness.

22. Growth with controls, various groups

23. Bilateral trade: real exchange volatility

24. Bilateral trade and exchange rate regime

25. Non-floating regimes more conducive to “consumption smoothing” capital flows… … composition of inflows may differ across regimes * Full sample; similar results for open capital account cases.

26. Systemic Interactions

27. Susceptibility to currency crisis greater for intermediate regimes* * * * Logistic regression showing likelihood of currency crisis, in percent of regime observations, controlling for other crisis determinants.

28. Susceptibility to financial crisis greater for non-floating regimes * * * Logistic regression showing likelihood of financial crisis (open capital account), in percent of regime observations, controlling for other crisis determinants. Financial crisis refers to sudden stop, debt, or banking crisis; open capital account refers to above-sample median of the IMF AREAR-based Ito Chinn index of capital controls.

29. External imbalances larger under non-floating regimes

30. Imbalances prior to an abrupt reversal larger under less flexible regimes

31. Higher abrupt reversal probability* for non-floats, especially EMEs… … and reversal of deficits that developed under pegs bigger and more costly to reverse. * Reversal probability is defined as the frequency of reversal as a proportion of exchange rate regime observations

32. Surpluses are much more persistent under less flexible regimes • No threshold effects under floats • Autoregressive coefficient about 0.50 (i.e. half life of one year) • Threshold effects significant under pegs and intermediates • Threshold effects are negative when current account is in deficit  large deficits unwind more abruptly • Threshold effect is positive when the current account is in surplus  once surpluses become large they also become highly persistent • Confirms early literature that less flexible regimes tend to impede adjustment of external imbalances 31

33. Systemic Risks

34. Reserve accumulation—no end in sight?

35. Beyond traditional prudential metrics… (but maybe domestic and AE financial crisis should be a new metric?) Reserves as a percent of imports of goods and services Reserves as percent of short-term debt

36. …and heavily concentrated

37. Do reserves enhance growth resilience? 36

38. How to reduce demand for self insurance? • Reserve accumulation inefficient and costly (but nonetheless likely to rise further): • 1st best: Market based insurance (but no quick fix: moral hazard; counterparty risk) • 2nd best: IMF lending • 3rd best: self insurance • What can the IMF do to reduce self insurance? • Going beyond the FCL (predictability, duration, stigma, access) • New forms of support (replace CB swap lines; assisting regional pools) • Apart from IMF lending toolkit, more effective surveillance • How to reduce self-insurance in U.S. dollars? • Multiple reserve currencies? • Transition • Policy discipline across multiple issuers? • Greater role for SDRs • Cyclically triggered global allocations? IMFC directs Fund to further improve its lending toolkit to reduce self insurance (Istanbul Communiqué, 2009)

39. Global imbalances: a temporary narrowing? • Connection with regime? • Inflexible regimes associated with larger and more persistent current account imbalances • Surpluses highly persistent under pegs • Reducing systemic risks • Greater exchange rate flexibility in key surplus countries • Measures to raise national saving in systemic deficit countries (multilateral consultation) • New multilateral surveillance procedure? projections

40. Is a tipping point for the dollar on the cards? • Tipping point: in flow or stock terms? • In flows—could be disorderly • In stocks—would be highly disruptive • How likely? Two views: • Gradual shift (Chinn and Frankel (2008)) • Abrupt shift possible (Eichengreen and Flandreau (2008)) • Is the world overweight dollars? • Simulations suggest that shares are not far off plausible “equilibrium” • Abrupt change in the stock of U.S. dollar assets held as reserves is a tail risk (particularly given concentration of holdings) • Measures to reduce tipping point risk • Exit policies to sustain confidence • Measures to narrow global imbalances • Policy coordination (lessons from the interwar period? Substitution account?) Currency composition of reserves (%):

41. Key messages • No one-size-fits-all: tailor regime to country characteristics and goals • Except for systemic countries with pegs? • Benefits from pegged and intermediate regimes for both EMEs and developing countries—new finding relative to previous IMF reviews • Benefits of less flexible regimes • Better inflation and growth performance • Better trade integration, more consumption-smoothing capital flows • Costs of less flexible regimes • Loss of monetary and fiscal autonomy • Greater susceptibility to financial crisis • Reduced facility in unwinding external imbalances • Larger and more persistent current account surpluses • Greater likelihood of an abrupt and more costly reversal of large deficits • Key issues going forward • Scramble for reserves • Global imbalances • Sudden tipping point in reserve currency status of the dollar • Role for policy and coordination in managing risks