Exchange Rate Regimes: Is the Bipolar View Correct?
During the past decade, many countries have changed their exchange rate regimes, moving from crisis-prone soft pegs to hard pegs or floating regimes. This trend is likely to continue, particularly among emerging market countries.
In recent years, fixed or pegged exchange rates have been a factor in every major emerging market financial crisis—Mexico at the end of 1994; Thailand, Indonesia, and Korea in 1997; Russia and Brazil in 1998; Argentina and Turkey in 2000; and Turkey again in 2001. Emerging market countries without pegged rates—including South Africa, Israel, Mexico, and Turkey in 1998—have been able to avoid such crises.
No wonder many policymakers now warn against the use of pegged but adjustable rates (soft pegs) in countries open to capital flows. This belief that intermediate regimes between hard pegs and free floating are unsustainable is known as the bipolar view, or two-corner solution. Willingly or otherwise, a growing number of countries have come to accept it. The proportion of IMF members with intermediate arrangements fell during the 1990s, while the use of hard pegs and more flexible arrangements rose (Chart 1).
Proponents of the bipolar view—myself included—have perhaps exaggerated their argument for dramatic effect. The correct formulation probably goes as follows. For countries open to international capital flows, (1) pegs are not sustainable unless they are very hard indeed, (2) a wide variety of flexible rate arrangements are possible, and (3) most countries' policies will still take some account of exchange rate movements.
Countries open to capital flows can adopt a wide range of arrangements, from free floating to a variety of crawling pegs with broad bands around them (under which the central exchange rate is frequently and marginally adjusted), as well as very hard pegs sustained by policy commitments such as currency boards, dollarization (or, more generally, the adoption of another foreign currency as legal tender), or membership in a currency union. But what does this exclude? In essence, fixed, adjustable-peg, and narrow-band systems, in which a government is committed to defending a particular value (or range of values) of the exchange rate, but is not committed to devoting monetary (and, on occasion, fiscal) policy solely to the goal of defending the parity.
Developed and emerging market countries
Many developed and emerging market economies open to capital flows moved away from adjustable-peg regimes during the 1990s—some toward harder pegs, but more toward regimes with greater flexibility (Chart 2).
Of the 33 countries classified as emerging market economies by J.P. Morgan or Morgan Stanley Capital International, the proportion with intermediate regimes fell from 64 percent to 42 percent over the decade. By the end of 1999, 16 of these countries had floating rates and 3 had very hard pegs in the form of currency boards or no legal tender. The remainder had intermediate arrangements: five crawling bands, one horizontal band, one crawling peg, and seven fixed pegs (Chart 3). The hollowing out of intermediate regimes among emerging market economies has continued since the end of 1999, with Greece moving from a horizontal band to membership in the euro and Turkey moving from a crawling peg to a float.
Hollowing out was also evident among the developed economies during the 1990s, a process dominated by the creation of the euro and the demise of the European exchange rate mechanism. By the end of 1999, half the economies characterized as developed by Morgan Stanley Capital International had very hard pegs and almost half had floating rates. Only one—Denmark—had an intermediate regime in the form of a horizontal band.
Soft pegs have simply not proved viable over time, especially for countries integrated or integrating into international capital markets. This point has been brought home by numerous currency crises as far back as the early 1970s, which have demonstrated the power of the "impossible trinity"—a country cannot simultaneously maintain a fixed exchange rate, capital mobility, and a monetary policy dedicated to domestic goals.
But why do policymakers seem incapable of directing domestic monetary policy credibly toward the sole objective of maintaining a fixed exchange rate? Despite some exceptions, the answer must be that if politicians have an opportunity to change the exchange rate at a time when the short-run benefits seem to outweigh the costs, they are likely to change it. And financial market participants know this.
Foreign and domestic economic shocks may move the nominal exchange rate away from the official rate. Defending an overvalued exchange rate peg then typically requires monetary and fiscal tightening to reduce the current account deficit and discourage capital outflows. If the overvaluation is small—and the necessary policy actions are taken—the situation can generally be stabilized. But if it is large, the required policy actions may not be politically or economically feasible and an attack on the peg is likely to succeed.
But why not impose capital controls to protect the exchange rate from the effects of disruptive capital flows? China used such controls in avoiding the effects of the Asian crisis in 1997 and 1998. Malaysia also imposed controls and pegged the exchange rate in September 1998, although it is more difficult to evaluate the effects of these actions, since the first part of the crisis was over by that time and most of the capital that wanted to leave had already done so.
We have to distinguish between controls on outflows and those on inflows. Controls on capital outflows can be used to help maintain a pegged exchange rate, given consistent domestic policies. However, they tend to lose their effectiveness over time and they cause other problems. Capital inflow controls may, for a time, allow a country to run an independent monetary policy when an exchange rate is softly pegged—and may influence the composition of capital inflows. But their long-term effectiveness is doubtful.
For controls on outflows to succeed, they need to be quite extensive. But, as a country develops, such controls become more distorting and less effective. (Attempts to impose controls on outflows once a crisis has begun tend to be ineffective.) Outflow controls should be removed gradually, at a time when the exchange rate is not under pressure, and as an efficient infrastructure of strong financial institutions and foreign exchange markets is introduced. Prudential regulations, such as limits on the foreign exchange positions that domestic institutions can take, may also be imposed as capital controls are removed.
Capital inflow controls can play a useful role for a time, and the IMF has cautiously supported them in some cases. Controls of this sort can help a country seeking to avoid the difficulties capital inflows can pose for domestic policy. Chile is the most frequently cited example, where controls were successful for a time in allowing some monetary policy independence. But even Chile's controls appeared to have lost their effectiveness after 1998, and they were recently removed.
Fear of floating
Calvo and Reinhart (2000) and others have emphasized that many countries that claim to have floating exchange rates do not in practice allow the rate to float freely, but use interest rate and intervention policies to affect its behavior. From this, they draw two conclusions: first, that it is incorrect to claim that countries are moving away from adjustable-peg systems and, second, that since countries hanker after fixed exchange rates for good reasons, they would be well advised to adopt hard pegs.
It is hardly surprising that most policymakers are concerned with the behavior of both nominal and real exchange rates. Changes in the former are likely to affect the inflation rate, while changes in the latter may affect both the wealth of domestic citizens and the allocation of resources, with large political consequences. Thus, monetary policy in countries with floating exchange rate systems is likely to respond to movements of the exchange rate.
This is certainly often the case in many smaller emerging economies and in most of the Group of Seven industrial countries (although seldom, if ever, in the United States). In countries with an inflation-targeting approach, movements in the exchange rate are taken into account in setting monetary policy because they affect price behavior. Many recent converts to floating have opted for an inflation-targeting approach, and the approach seems to be succeeding.
Why should monetary policy not target both the nominal exchange rate and the inflation rate? Certainly, the pressure on central banks at times when the real exchange rate has appreciated and the current account is in large deficit forces them to confront this issue. The first answer is that monetary policy fundamentally affects the nominal and not the real exchange rate. It is fiscal policy that should take care of the current account.
There is, however, an unresolved issue about whether monetary policy in a floating rate system should be used in the short run to try to affect the exchange rate. Although this issue has not received much empirical attention, there is almost certainly a short-run trade-off between the real exchange rate and inflation, analogous to the Phillips curve, that would be considered in monetary policy formulation.
Viable hard pegs
At the end of last year, 47 of the IMF's member countries had hard-peg exchange rate systems, either with no independent legal tender or with a currency board. Except for the 11 countries in European Economic and Monetary Union (EMU)—a large exception—all the economies with no independent legal tender were small. Argentina and Hong Kong SAR are the largest economies with currency boards. It is hard to evaluate a priori the benefits and costs of the constraints imposed by the commitment to a currency board.
The record shows that, for a country with a history of extreme monetary disorder, introducing a currency board is a way to gain credibility for monetary policy more rapidly and at a lower cost than appears possible any other way.
Those observers who strongly favor hard pegs, such as Calvo and Reinhart, tend to focus on the capital account and asset markets. They argue that, with respect to asset markets, a country obtains essentially no benefit from exchange rate flexibility. Given this, they argue for going even beyond currency boards to dollarization and, perhaps, in the longer run to wider currency unions.
I believe that hard pegs are more attractive today, particularly when viewed from the asset markets, than had been thought some years ago. A small economy that depends heavily on a particular large economy for its trade and capital account transactions may wish to adopt that country's currency. But it will need to give careful consideration to the nature of the shocks that affect it before the choice is made.
It is reasonable to believe, as EMU expands and as other economies reconsider whether to maintain a national currency, that more countries will adopt very hard pegs and that there will be fewer national currencies in the future.
The exchange rate as a nominal anchor
The benefits and risks of using the exchange rate as a nominal anchor to reduce inflation in countries with triple-digit inflation have been extensively studied. There are few instances in which disinflation from such high levels has succeeded without the use of an exchange rate anchor, possibly a crawling peg.
Unless the disinflating country adopts a hard peg, it has to consider different strategies for exiting from its pegged arrangement, that is, moving toward a more flexible system. Of 12 countries that have undertaken major exchange rate stabilizations since the late 1980s, 4 have entered currency boards and disinflated successfully, and 8 have either undertaken step devaluations or introduced crawling bands.
A study of exit strategies (Eichengreen and others, 1998) shows that a country is better off exiting when its currency is strong, which is likely to happen as stabilization gains credibility and capital flows expand. This happened in Poland and Israel, where the band was widened as pressure grew for currency appreciation. Even in such a case, however, the political economy of moving away from a peg is complicated: when a currency is strong, the authorities see no reason to move off the peg; when it is weak, they argue that devaluing or widening the band would be counterproductive. The longer the peg continues, the more the dangers associated with soft pegs grow. In some cases in which disinflating countries' currencies crashed, the IMF had been pushing unsuccessfully for greater exchange rate flexibility.
Big three exchange rates
The instability of exchange rates among the major currencies is a perennial concern. Movements in rates among the big three currencies—the dollar, the euro, and the yen—can create difficulties for other countries, particularly those that peg to one of those currencies. For example, the appreciation of the dollar that began in 1995 adversely affected exports of the East Asian countries, while the dollar's strengthening also contributed to the difficulties Argentina and Turkey faced in 2000.
There have been frequent proposals for target zones among the three major currencies. In practice, such a system appears to operate informally and loosely. When exchange rates get too far out of line with fundamentals, two or three of the big three agree to intervene in currency markets. This happened in mid-1995, when the yen appreciated, and in the fall of 2000, when the euro depreciated significantly.
This informal system differs from a formal target zone in three ways. First, there are no preannounced target zones and so no commitment to intervene at any particular level. Second, the informal system operates more through coordinated exchange market interventions than through coordinated monetary policy actions. Third, such interventions are rare. Nonetheless, this informal and loose system does provide some bounds on the extent to which exchange rates among the big three are likely to diverge from equilibrium.
Regimes for other countries
So far, I have focused on the exchange rate regimes for 55 developed and emerging market economies. The pattern has, however, been remarkably similar for the other IMF members. Even among countries without access to international capital markets, there has been a shift away from soft pegs toward hard pegs on the one side and more flexible regimes on the other (Chart 4). On balance, these countries are more likely to have hard pegs than the emerging market economies and less likely to have floating rates or soft pegs.
Further research is needed on the characteristics of exchange rate systems and accompanying financial sector policies that are most suited to particular types of countries that are not yet integrated into the global financial system.
The trend away from softly pegged exchange rate regimes toward floating rates and hard pegs appears to be well established, both for countries that are integrated into international capital markets and those that are not. This is no bad thing and it looks set to continue.
This article is based on the author's paper, which he delivered as the Distinguished Lecture on Economics in Government at the American Economics Association meeting in New Orleans in January 2001. The full text of the paper is available at http://www.imf.org/external/np/speeches/2001/010601a.htm. It is also published in the Spring 2001 issue of the Journal of Economic Perspectives.