Exchange Rate Regimes Jeffrey Frankel Harpel Chair, Harvard University IMF Institute

1. Exchange Rate Regimes Jeffrey Frankel Harpel Chair, Harvard University IMF Institute  * April 27, 2011 *

2. Topics to be covered • I. Classifying countries by exchange rate regime • Statistical inference of de facto regimes • II. Advantages of fixed rates • The trade-promoting effect of currency unions & the € case • III. Advantages of floating rates • IV. Which regime dominates? • V. Additional factors for developing countries • Emigrants’ remittances • Financial development • Terms-of-trade shocks • Alternative nominal anchors • Proposal for Product PriceTargeting • Appendices PPT

3. I. Classification of exchange rate regimes: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

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)

5. 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. II. Economists offer de facto classifications, placing countries into the “true” categories • Important examples include Ghosh, Gulde & Wolf(2000),Reinhart & Rogoff(2004),Shambaugh(2004a), • & more to be cited. • Tavlas, Dellas & Stockman (2008) survey the literature. • Unfortunately, these classification schemes disagree with each other as much as they disagree with the de jure classification! [1] • => Something must be wrong.[1] Bénassy-Quéré, et al(Table 5, 2004);Frankel(Table 1, 2004); and Shambaugh(2007).

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

8. => Something must be wrong. Several things are wrong. Difficulty #1:Attempts to infer statistically a currency’s flexibility from the variability of its exchange rate alone ignore that some countries experience greater shocks than others. That problem can be addressed by comparing exchange rate variability to foreign exchange reserve variability: • Calvo & Reinhart (2002); Levy-Yeyati & Sturzenegger (2003, 05).

9. Korea & Singapore in 2010 took 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”) GS Global ECS Research

10. In Latin America, renewed inflows are 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

11. This 1st approach can be phrased in terms of Exchange Market Pressure: • Define ΔEMP = Δ value of currency + xΔreserves. • ΔEMP 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). x ≡ 1/MBaseor sometimes the inverse relative variance.

12. In Asia since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; HongKong & Singapore the least, followed by Malaysia&China. Goldman Sachs Global Economics Weekly 11/07Feb. 16, 2011

13. 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.

14. Several things are wrong,continued. Difficulty #2:We shouldn’t impose the choice of the major currency around which the country in question defines its value (often the $). • It would be better to estimate endogenously whether the anchor currency is the $, the €, some other currency, or some basket of currencies. • That problem has been addressed by a 2nd approach.

15. Some currencies have basket anchors, often with some flexibility that can be captured either by a band (BBC) or by leaning-against-the-wind intervention. • Most basket peggers keep the weights secret. They want to preserve a degree of freedom from prying eyes,whether to pursue • less de facto flexibility, as China, • or more, as with most others.

16. The 2nd approach in the de facto regime literature estimates implicit basket weights: • To uncover the currency composition & weights, regress changes in log H, the home currency value, against changes in log values of candidate currencies. • Algebraically, if the value of the home currency is pegged to the values of currencies X1, X2, … & Xn, with weights equal to w1, w2, … & wn, then ΔlogH(t) =c + ∑ w(j) [ΔlogX(j)] (1)

17. The technique to estimate basket weights • First examples: Frankel (1993) and Frankel & Wei (1994, 95). • More: Bénassy-Quéré (1999), Ohno (1999), Bénassy-Quéré, Coeuré & Mignon (2004)…. • Application to the RMB, post 7/05: • Shah, Zeileis & Patnaik (2005), Eichengreen (2006), Ogawa (2006), Yamazaki (2006), Frankel-Wei (2006, 07), Frankel (2009).

18. Implicit basket weights method -- regress Δvalue of local currency against Δ values of major currencies --continued. Null Hypotheses: Close fit => a peg. Coefficient of 1 on $ => $ peg. Or significant weights on other currencies => basket peg. But if the test rejects tight basket peg, what is the Alternative Hypothesis? Professor Jeffrey Frankel

19. Difficulty #3: The 2nd approach (inferring the anchor currency or basket) does not allow for flexibility around that anchor. Inferring de facto weights and inferring de facto flexibility are equally important, whereas most authors do only one or the other. Several things are wrong, continued. Professor Jeffrey Frankel

20. The synthesis technique • => We need a technique that can cover both dimensions: inferring weights and inferring flexibility. • A synthesis of the two approaches for statistically estimating de facto exchange rate regimes:(1) the technique that we have used in the past to estimate implicit de facto weights when the hypothesis is a basket peg with little flexibility. + (2) the technique used by others to estimate de facto exchange rate flexibility when the hypothesis is an anchor to the $, but with variation around that anchor.

21. Synthesis equation Δ logH(t) = c + ∑ w(j) Δ[logX(j, t)] + ß {Δ EMP(t)} + u(t) (2) where Δ EMP(t) ≡ Δ[logH(t)] + [ΔRes(t) / MB(t)].

22. Several things are wrong, continued. Difficulty #4:All these approaches are plagued by the problem that many countries frequently change regimes or change parameters. E.g., Chile’s BBC changed parameters 18 times in 18 years (1980s-90s) Year-by-year estimation won’t work, because parameter changes come at irregular intervals. Chow test won’t work, because one does not usually know the candidate dates. Solution: Apply Bai-Perron (1998, 2003) technique for endogenous estimation of structural break point dates. Professor Jeffrey Frankel

23. Statistical estimation of de facto exchange rate regimes Synthesis: “Estimation of De Facto Exchange Rate Regimes: Synthesis of the Techniques for Inferring Flexibility and Basket Weights”Frankel & Wei (IMF SP2008) Estimation of implicit weightsin basket peg: Frankel(1993),Frankel & Wei(1993, 94, 95);Ohno (1999), F, Schmukler & Servén(2000),Bénassy-Quéré (1999, 2006)… Estimation of degree of flexibilityin managed float: Calvo & Reinhart (2002); Levi-Yeyati & Sturzenegger (2003)… Application to RMB:Eichengreen (06), Ogawa (06), F & Wei (07) Application to RMB: Frankel(2009) Econometric estimation of structural break points: Bai & Perron(1998, 2003) Allow for parameter variation: “Estimation of De Facto Flexibility Parameter and Basket Weights in Evolving Exchange Rate Regimes”F & Xie (AER, 2010) Professor Jeffrey Frankel

24. Bottom line on classifying exchange rate regimes • It is genuinely difficult to classify most countries’ de facto regimes: intermediate regimes that change over time. • Need techniques • that allow for intermediate regimes (managed floating and basket anchors) • and that allow the parameters to change over time.

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

26. 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 such as Inflation Targeting 4) Avoid competitive depreciation 5) Avoid speculative bubbles that afflict floating.(If variability were all fundamental real exchange rate risk, and no bubbles, then fixing the nominal rate would mean it would just pop up in prices instead.)

27. Influential finding of Rose(2000): the boost to bilateral trade from currency unions is • significant, • ≈ boost from FTAs, & • larger (3-fold) than had been thought. • Many others have advanced critiques of Rose research, re: • endogeneity of currency decision, • small countries ≠ large, • missing variables & • implausibility of sheer magnitude. • Estimated magnitudes are often smaller, but the basic finding has withstood perturbations and replications well.ii/ • Parsley-Wei: currency effect explains border effects. [ii] E.g., Rose & van Wincoop (2001); Tenreyro & Barro (2003). Survey: Baldwin (2006)

28. Endogeneity of OCA criteria: • Trade responds positively to currency regime • A pair’s cyclical correlation rises too(rather than falling, as under Eichengreen-Krugman hypothesis)Frankel & Rose,EJ

29. III. Advantages of floating rates • Monetary independence • Automatic adjustment to trade shocks • Retain seignorage • 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.)

30. IV. Which dominate: advantages of fixing or advantages of floating?Performance by category is inconclusive. • To over-simplify findings of 3 important studies: • Ghosh, Gulde & Wolf: hard pegs work best • Sturzenegger & Levy-Yeyati: floats perform best • Reinhart-Rogoff: limited flexibility is best • Why the different answers? • Conditioning factors. • The de facto schemes do not correspond to each other.

31. Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances, of course: 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.

32. 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, by first observing that smaller units tend to be more open and integrated. Then 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 that it would be better off splitting into sub-regions with different currencies.

33. Optimum Currency Area criteria for fixing exchange rate: • Small size & 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.

34. Popularity in the 1990s of the institutionally-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) • monetary union (e.g., EMU, 1999)

35. 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.

36. V. Three additional considerations, particularly relevant to developing countries • (i) Emigrants’ remittances • (ii) Level of financial development • (iii) External terms of trade shocks, alternative nominal anchors, and the proposal for Product Price Targeting.

37. (i) I would like to add another criterionto the traditional OCA list:Cyclically-stabilizing emigrants’ remittances. • If country S has sent many immigrants to country H, and their remittances are correlated with the differential in growth or employment in S versus H, this strengthens the case for S pegging to H. • Why? It helps stabilize S’s current account even when S has given up ability to devalue. • But are remittances stabilizing? • as private capital flows promise to be in theory, but fail in practice?

38. (i) I would like to add another criterionto 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 S’s current account even when S has given up ability to devalue.

39. (ii) Level of financial developmentAghion, Bacchetta, Ranciere & Rogoff (2005) • Fixed rates are better for countries at low levels of financial development: because markets are thin => benefits of accommodating real shocks are outweighed by costs of financial shocks. • When financial markets develop, exchange flexibility becomes more attractive. • Estimated threshold: Private Credit/GDP > 40%.

40. Level of financial development, cont.Husain, Mody & Rogoff (2005) • For poor countries with low capital mobility, pegs work • in the sense of being more durable • & delivering low inflation. • For richer & more financially developed countries, flexible rates work better • in the sense of being more durable • & delivering higher growth without inflation

41. (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). • One case of supply shocks: natural disasters • E.g., Ramcharan (2007).. • Most common case of real shocks: trade • Edwards & Levy-Yeyati (2003):Empirically, among peggers terms-of-trade shocks are amplified and long-run growth falls, as compared to flexible-rate countries.

42. Terms-of-trade variability returns • Prices of crude oil and other agricultural & mineral commodities hit record highs during the decade 2001-2011. • => Favorable terms of trade shocks for some (oil producers; South America, Africa, etc.); • => Unfavorable terms of trade shock for others (oil importers, such as Asia)..

43. Nominal anchors for monetary policy If the exchange rate is not to be nominal anchor, something else must be… especially where institutions lack credibility 2 alternatives for nominal anchor have had ardent supporters in the past, but are no longer in the running: the price of gold, as 19th century gold standard; and the money supply, the choice of monetarists. Inflation targeting Orthodox implementation: the CPI Unorthodox versions for countries with volatile terms of trade IT PPT

44. Fashions in international currency policy • 1980-82: Monetarism (target the money supply) • 1984-1997: Fixed exchange rates (including currency boards) • 1993-2001: The corners hypothesis • 1998-2009: Inflation targeting (+ currency float) became the new conventional wisdom • Among academic economists • Among central bankers • At the IMF

45. 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

46. After the 1990s’ EM Crises, Inflation Targetingspread from rich countries to emerging markets IT Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer in the IMF, Monetary and Exchange Affairs Dept. Online at: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdfThe background papers for the high-level seminar “Implementing Inflation Targets,” held in Washington in March 2000, are available on the IMF Website: http://www.imf.org/external/pubs/ft/seminar/2000/targets/index.htm

47. The shocks of 2008-2011 showed disadvantages to Inflation Targeting, analogously to how the EM crises of the 1994-2001showed 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

48. 6 proposed nominal targets and the Achilles heel of each: IT Professor Jeffrey Frankel

49. 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 a basket that gives heavy weight to prices of its commodity exports, rather than to the $ or € or CPI. • 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. Professor Jeffrey Frankel

50. 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 consumption do not cover 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….