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IMF Publications on:
Exchange Rate Regimes
Exchange Rate Regimes
Kenneth S. Rogoff, Aasim M. Husain, Ashoka Mody, Robin Brooks, and Nienke Oomes
©2004 International Monetary Fund
May 24, 2004
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This study assesses the historical durability and performance of alternative exchange rate regimes, with special focus on developing and emerging market countries. It suggests that the popular bipolar view of exchange rates is neither an accurate description of the past nor a likely scenario for the next decade. While the study confirms that emerging market countries need to consider adopting more flexible exchange rate regimes as they develop economically and institutionally, it also finds that fixed or relatively rigid exchange rate regimes have not performed badly for poorer countries. For countries that have relatively limited financial market development and relatively closed capital markets, fixed exchange rate regimes appear to offer some measure of credibility without compromising growth objectives—with the important proviso that monetary policy must be consistent in avoiding a large and volatile parallel market premium. As countries develop economically and institutionally, there are considerable benefits to adopting a more flexible exchange rate system—although, of course, the following analysis provides only a general guide and should not be interpreted as a one-size-fits-all prescription. For developed countries that are not in a currency union (or headed toward one), relatively flexible exchange rate regimes offer higher growth without any cost in anti-inflation credibility—provided they are anchored by some other means, such as an independent central bank with a clear anti-inflation mandate. One perhaps surprising finding of the quantitative analysis is the remarkable durability of exchange rate regimes outside of emerging market countries, with only 7 percent of all countries changing regimes in an average year over the 1940–2001 period.
Debates on the appropriate exchange rate regime for a country are perennially lively. In the 1990s, a new set of considerations came to the fore, particularly the role played by international capital flows and domestic financial systems in determining the performance of exchange rate regimes. Just when pegged regimes were gaining respectability as providing nominal anchors, several pegs (and crawling pegs) faced speculative pressures from investors who were skeptical of the regimes' sustainability. Many such episodes were associated with costly financial crises, especially in emerging markets. One influential view predicted that exchange rate regimes would move in a bipolar manner to the extremes of hard pegs, which would be relatively immune to speculative pressures or free floats (Eichengreen, 1994; and Fischer, 2001). An increasing number of countries did announce their intent to allow greater exchange rate flexibility. Among developing and emerging market economies, however, the de jure announcement to float did not typically translate into de facto fully floating exchange rates. Countries, it appeared, had a fear of floating (Calvo and Reinhart, 2002).
These observed trends and policy ambivalence reflected a variety of opposing considerations in the adoption and performance of exchange rate regimes. In their discussions of papers on exchange rate regimes in September and November 1999, IMF Executive Directors concluded that there were no simple prescriptions for the choice of a country's exchange rate regime.1 Instead, they emphasized the importance of macroeconomic fundamentals and the consistency of the exchange rate regime with underlying macroeconomic policies. Several also thought that a range of alternatives between the polar extremes of rigidity and flexibility were viable. More recently, however, the IMF has been urged—from outside as well as within—to take a more prescriptive role in its surveillance of members' exchange rate policies and regime choice, underscoring the importance of an improved understanding of the performance of alternate regimes (Calomiris, 1998; International Financial Institution Advisory Commission, 2000; Mussa, 2002; and IMF, Independent Evaluation Office, 2003c).
While recognizing the central importance of macroeconomic fundamentals, this study uses recent advances in the classification of exchange rate regimes to draw new lessons from the performance of alternative regimes. The findings indicate that, as economies and their institutions mature, the value of exchange rate flexibility increases. This conclusion reflects distinctions among advanced, emerging, and other developing economies. Emerging markets have stronger links to international capital markets than do other developing economies. Unlike advanced economies, however, emerging markets face a variety of institutional weaknesses that manifest themselves in higher inflation, problems of debt sustainability, fragile banking systems, and other sources of macroeconomic volatility, all of which potentially undermine the credibility of policymakers. Thus, while the non-emerging market developing countries (hereinafter referred to as developing economies) may gain credibility through pegging their exchange rates, emerging market economies find it harder to do so and could benefit from investing in learning to float. More advanced economies, with their stronger institutions, are best positioned to enjoy the benefits of flexibility without the risk of losing policy credibility.
To be clear, this study takes as a given the current conjuncture of a multiplicity of currencies. As such, the conclusions apply to those countries that have their own currencies. It is possible, however, that the current context may evolve, and a sufficiently large number of countries may, in the next decade and beyond, elect to join currency unions, leading to fewer currencies in circulation. This would change the behavior of governments and international business, and, hence, change the economic performance of alternative regimes in ways that the following does not attempt to predict.2
Because analytical arguments on the economic influence of exchange rate regimes often lead to opposing conclusions, this study bases its perspective on actual experience. Empirical observations are used to form judgments on how offsetting factors play out in different country groups. The simple groupings do not allow for complexities at the level of individual countries, however, by reflecting, for example, their economic size and internal heterogeneity.
Empirical analysis of exchange rate regime performance depends, of course, on the classification of regimes. The conclusions of this study rely on the distinction between de jure and de facto regimes. Owing to the importance of this distinction, attempts have been made in recent years to characterize de facto regimes using information on the actual behavior of exchange rates that is supplemented by data on the movement of foreign exchange reserves and interest rates, as well as judgments on the true intent of policymakers. Based on such an effort, the IMF now compiles the de facto exchange rate regimes of its member countries, dating back to 1990 (IMF, 1999 and 2003b). The de facto regime classification principally used in this study is the "Natural" classification proposed by Reinhart and Rogoff (2004) which is available from the 1940s for virtually all IMF member countries. Among its distinguishing features is the use of parallel market exchange rates to determine the actual operation of an exchange rate regime and the identification of a separate category of freely falling regimes that are characterized by high inflation, and thus, implicitly, by weak macroeconomic management.
This study has two additional main sections. Section II first discusses several alternative exchange rate regime classification systems and reviews perspectives they offer. It describes trends in the distribution of regimes, noting the difference between de jure trends, which show a move to flexibility, and de facto trends, which show that intermediate exchange rate arrangements are still pervasive. The section also examines the transitions between regimes and finds that de facto regimes tend to be long-lived. The bulk of the de facto regime transitions in the past half century have occurred in the wake of exceptional events, such as the breakdown of the Bretton Woods system, the creation of the European Economic and Monetary Union, and the collapse of the Soviet Union. In the absence of such events, the present global distribution of regimes is not likely to change substantially. Over the longer term, however, political economy considerations may guide regime choice in some countries, possibly resulting in their election to form or join a currency union. Such transitions, of course, are beyond the scope of this analysis.
Section III studies the performance of exchange rate regimes in terms of inflation and business cycles. It finds that the advantages of exchange rate flexibility increase as a country becomes more integrated into global capital markets and develops a sound financial system. Free floats have, on average, registered faster growth than other regimes in advanced countries, without incurring higher inflation. Conversely, in developing countries with limited access to private external capital, pegs and other limited-flexibility arrangements have also been associated with lower inflation, without an apparent cost in terms of lower growth or higher growth volatility. In emerging market economies with higher exposure to international capital flows, however, the more rigid regimes have had a higher incidence of crises. The analysis also indicates that macroeconomic performance under all types of de facto regimes was weaker in countries with dual or multiple exchange rates that deviated substantially from official rates, suggesting important gains from exchange rate unification.
The analysis and results in this study are subject to a number of qualifications. First, empirical findings may reflect in part the influence of economic performance on the choice of regime, rather than the other way around. Second, an inherent difficulty arises in classifying regimes in a fully specified manner. A country's true exchange rate regime is, properly speaking, a super regime consisting of a sequence of regimes and not just the one that prevails at a particular point in time. Thus, the harmful effects of a regime may be observed only when it collapses, leading to a misattribution of the poor performance to the successor regime. Third, some of the conclusions depend on the choice of the Natural classification. To the extent possible, such conclusions are compared with results obtained using other classifications to assess the robustness of the conclusion or to explain why the differences arise. Fourth, the need for caution arises from the fact that, although a country's regime is conventionally classified as fixed, if its currency is fixed with respect to a single other currency, then performance is a function of multiple relationships with all partner currencies. The combining of multiple relationships into one has both descriptive and prescriptive consequences. For example, in classifying Argentina as a hard peg case, one loses sight of the fact that, in relation to the great majority of its trading partners, the peg to the dollar made it a floater. Finally, further analysis is needed to jointly classify exchange rate regimes and capital account openness. For all these reasons, while the conclusions and policy implications drawn in this study offer new cross-country perspectives on exchange rate regimes, the results should be interpreted with suitable caution, especially for individual cases.
1See the summings up of IMF Board discussions in Mussa and others (2000).
2IMF (2003a) concludes, however, that while Group of Three (G-3) exchange rate volatility has real effects, especially on some countries with high debt ratios and mismatches in trade and financial flows, the overall effects are small.