SWITCHING FROM FLOAT TO PEG: Nuanced View SCOPE AND FINDINGS. Switching from float to peg presents the

Transcription

1 SWITCHING FROM FLOAT TO PEG: Nuanced View By Assaf Razin and Yona Rubinstein (In progress, January 15, 2003) SCOPE AND FINDINGS Switching from float to peg presents the economy with a tradeoff: the risk of a currency crisis is aggravated, but once a currency crisis is avoided the economy performs better than under a float. By pegging their currencies to international moneys (the Dollar or the Euro), countries that are rapidly accumulating exchange reserves through export growth, and able to maintain a high saving ratio, provide certainty to business, and profit margins to

2 investors, based on a low and stable (world) rate of interest. Therefore, if the economy retains the confidence of the international investors under a peg, output growth is enhanced, while inflation remains low. However, with large budget and trade deficits, and free-market policies that facilitate the outflow of capital, the country becomes vulnerable to sudden stops of capital inflows, and currency crises. As Paul Krugman puts it, concerning the 1990s Argentina-currency-board (a hard form of currency peg) experiment: Argentina, once a showpiece for the new world order, quickly became a byword for economic catastrophe (The New York Times, January 6, 2004). Consider, in contrast to Argentina, the case of Israel s 1985 inflation -stabilization package, which

3 has inter alia included a switch from a currency free fall to a peg. There was a huge upfront one-shot depreciation and a drastic fall in inflation rates (see Assaf Razin and Efraim Sadka, The Economy of Modern Israel: Malayse and Promise, University of Chicago Press, 1993). A drastic consolidation of the real budget imbalances, and the sharp cuts in real wages were, to a large extent, the consequence of the switch to the peg. These effects helped reduce inflation rates from three digits to low two digits. Israel has avoided significant currency crises while under the peg (except for one relatively minor crisis in December 1988), and output growth moved up to OECD rates. With both Argentina-type and Israel-type episodes in the data, the estimated effect of a policy switch, from a float to a peg, on output growth, could

4 turn out to be positive, negative, or zero. Because, the coefficient of the peg variable in a standard OLS regression captures, the sample average of the two conflicting effects of the peg. To analyze the relatively subtle mechanism of a switch from float to peg, while motivated by the ambiguous findings of the conventional empirical approach, we develop in this paper a new empirical approach. We define an episode of a currency crisis by a large percentage fall in the real exchange rate. As a benchmark we first include the regression analysis the actual currency-crisis measure. In this case we find that a peg has no discernible effect on output growth. In the first stage we estimate a measure of the probability of the crisis by PROBIT.

5 In the second stage we run an OLS regression in which we condition the output growth on a carefully selected state of nature. That is, the probability of the currency crisis which is estimated in the first stage. In this way we depart from the common practice of conditioning output growth on the actual crisis rather than the probability of crisis. Our findings accord with the theory: (1) The switch from a float to a peg raises the probability of the crisis, (2) The currency crisis, once realized, tends to reduce growth, (3) The peg raises output growth, given a crisis probability. Stanley Fischer (2001) puts the issue of the peg succinctly: Each of the major international capital

6 market-related crises since 1994 Mexico, in 1994, Thailand, Indonesia and Korea in 1997, Russia and Brazil in 1998, and Argentina and Turkey in 2000 has in some way involved a fixed or pegged exchange rate regime. At the same time, countries that did not have pegged rates among them South Africa, Israel in 1998, Mexico in 1998, and Turkey in 1998 avoided crises of the type that afflicted emerging market countries with pegged rates.

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8 Calvo and Reinhart (2000) and others have emphasized that many countries that claim to have floating exchange rates do not allow the exchange rate to float freely, but rather deploy interest rate

9 and intervention policy to affect its behavior. From this valid point they appear to draw two conclusions: first, that the claim that countries are moving away from adjustable peg exchange rate systems is incorrect; and second, that countries for good reasons hanker after fixed exchange rates, which they can best obtain through hard pegs.

10 Kenneth S. Rogoff (Finance and Development, Disinflation: An Unsung Benefit of Globalization December 2003, pp54-55) notes that Global inflation has dropped from around 30 percent a year in the early 1990s to under 4 percent today. Globalization, interacting with deregulation and privatization, has played a strong supporting role in

11 disinflation episodes. We recall that the disinflation episodes were to a large part associated with a switch from float to peg. Globalization increases competition. It therefore drives down inflation both directly (that is, cutting monopolistic mark-ups), and indirectly (that is, it diminishes the temptation of central bankers to create inflation surprises; because unanticipated inflation is less potent in raising output 1 ). This motivates us to investigate the two ingredients of the policy package jointly: the effect of a peg and capital controls on output. But we know that statement is that for countries open to international capital flows pegs are not always sustainable; when a peg is forced to be abandoned, inflation may reappear. 1 Assaf Razin and Chi-Wa Yuen ( The New Keynesian Phillips Curve: Closed Economy vs. Open Economy, Economic Letters, 75 (2002, pp. 1-9)), demonstrate that the aggregate supply relationship becomes flatter with increased openness. The worsening of the inflation-output tradeoff, perhaps, raises the weight central bankers put on the output gap in their loss function.

12 Although the full-fledged empirical relevance of our analysis remains to be demonstrated, it does appear to make a case for taking a nuanced view of the likely effects of a policy switch from a float to a peg on growth. Background It has been conspicuously difficult to identify clear-cut empirical real effect of monetary regimes on the open economy. Indeed, Marianne Baxter and Alan Stockman (1989, Business Cycle and Exchange Regime: Some International Evidence, Journal of Monetary Economics Vol. 23, ) and Robert P. Flood and Andy Rose (1995, Fixing Exchange Rates: A Virtual Quest for Fundamentals, Journal of Monetary Economics) find that there are no significant differences in business cycles across exchange rate regimes. An exception is an Economic

13 Policy paper by Andy Rose (Issue 30, 2000: pp. 7-45). In the paper Rose uses evidence from existing currency unions in the world economy, to estimate the effect of currency union on trade. Rose finds that a currency union, which is an extreme form of a peg), expands bilateral trade between two average member countries by a huge proportion (200% and more). Rose s analysis was challenged by Torsten Persson (Economic Policy, Volume 33). But he also find significant, albeit a more modest, effect of currency unions. The IMF standard official classification of exchange rate regimes prior to 1997, as described in the various issues of the IMF s Annual Report on Exchange Rate Arrangements and Exchange Rate Restrictions, was completely revamped by the pioneering work of Carmen Reinhart and Ken Rogoff

14 (2002, NBER Working Paper # 8963). They classify the regimes in a range from free falling to a hard peg like in the CFA franc zone in Africa. We look at episodes of a switch from broad categories of float (ranging from free falling, through freely floating, to managed floating) to broad categories of peg (ranging from limited flexibility to peg). They conjecture that the surprising results in Baxter and Stockman (1989), and Flood and Rose (1995), may owe to the fact that the official historical grouping of exchange rate regimes are somewhat misleading. Many developing countries, which switched from float to peg, did so as a means of stabilizing inflation. Both Israel (in 1985) and Argentina in (1991) switched from float to peg to underpin their anti- inflation policy package. Policy-switch episodes

15 of this type were common in Latin America throughout the 1990s. Potentially, such a switches may have two major effects on future output growth: The consequent low inflation-low rate of interest macroeconomic background is good for growth; but the possibility of a currency crisis, which is associated with the peg, is bad for output growth. The potential for a currency crisis, which existed both in the Israeli peg and the Argentina peg, is, however, unobserved. A significant currency crisis actually happened in Argentina, not in Israel, owing among other things, to a particular realization of domestic and external shocks. A regression that relates output growth to observed currency crises could not disentangle the good and the bad effects of the switch from float to peg. Because, in one case

16 (Israel) the actual effect was positive, while in the other case (Argentina) the actual effect was negative. There are two other issues that factor in the analysis of exchange-rate regime switch: capital controls and dollarization. Capital controls To be added. Dollarization Carmen Reinhart, Ken Rogoff and Miguel Savastano (2004, NBER Working Paper # 10015, forthcoming in the QJE) find that, dollarization appear to increase exchange rate pass-through, which may reinforce the claim that fear of floating is a greater problem for highly dollarized developing economies. Conventional wisdom suggests that a switch from a float to a peg reinforces dollarization.

17 Currency crises in dollarized economies are expected to be triggered by self-fulfilling expectations, and have adverse output effects through a balance-sheetcrisis mechanism (as in Paul Krugman (2000, in International Finance and Financial Crises: In Honor of Robert P. Flood, Jr., edited by Peter Isard, Assaf Razin and Andrew Rose, Boston: Kluwer Academic Publishers and IMF)). DATA Our data set consists of 105 low-and middle-income countries (48 African countries, 26 Asian countries, 26 countries from Latin America and the Caribbean and 5 European countries). The main source of data is the World Bank (World Development Indicators and Global Development Finance).The annual data ranges from 1971 to Data was assembled by Milesi-Ferretti and Razin

18 (2000, in Krugman (ed.), Currency Crises, University of Chicago Press). Framework of Analysis (i) OLS regression of growth on : (a) Controllers; (b) policy switch variables. (ii) OLS regression of growth on : (a) Controllers; (b) Country fixed effects, and (c) policy switch variables (ii) (iii) FE estimation with (a) Controllers; (b) policy switch variables, and (c) Probability- of- crisis estimate. (iv) FE - estimation procedure. Explanatory variables are: (a) Controllers; (b) policy switch variables. (c) A probability-estimate of crisis, and (d) Country fixed effects.

19 Current Account Reversals and Capital Controls Large Currency Depreciation Currency Stability Capital Flow Y 11 Y 12 Reversal Capital Flow Y 21 Y 22 Stability Y ij =growth in the ij-cell.

20 Two-stage Analysis: First stage: Probits of Capital Flow Reversals, and Large Currency Depreciations. Second Stage: Regressions of growth, conditioned on probabilities of Capital Flow Reversals, and Large Currency Depreciations. Controllers: world rate of interest, budget deficit, etc. Intuition: The capital-controls regime limits capital flow reversals; the exchange-rate peg regime raises the probability of an unexpected depreciation.

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26 Selected References Stanley Fischer, (2001) Exchange Rate Regimes: Is the Bipolar View Correct?, Delivered at the Meetings of the American Economic Association New Orleans, January 6, 2001 Ariyoshi, Akira, Karl Habermeier, Bernard Laurens, Inci Ötker-Robe, Jorge Iván Canales-Kriljenko, and Andrei Kirilenko (2000). Capital Controls: Country Experiences with Their Use and Liberalization, IMF Occasional Paper 190. Bhagwati, Jagdish (1998). "The Capital Myth", Foreign Affairs, 77, 3 (May-June), Broda, Christian (2000). "Coping with Terms of Trade Shocks: Pegs vs. Floats", in Alberto Alesina and Robert Barro (editors), Currency Unions, forthcoming. Stanford: Hoover Institution Press. Calvo, Guillermo A. (2000). "Capital Markets and the Exchange Rate, With Special Reference to the Dollarization Debate in Latin America", University of Maryland, (April). and Carmen M. Reinhart (2000). "Fear of Floating", NBER Working Paper 7993 (November). (2000). "Reflections on Dollarization", in Alberto Alesina and Robert Barro (editors), Currency Unions, forthcoming. Stanford: Hoover Institution Press., Carmen M. Reinhart, and Carlos A. Végh (1995). "Targeting the Real Exchange Rate: Theory and Evidence", Journal of Development Economics, 47, and Carlos Végh (1999). "Inflation Stabilization and BOP Crises in Developing Countries", NBER Working Paper Chang, Roberto and Andres Velasco (2000). "Exchange Rate Policy for Developing Countries", American Economic Review, Papers and Proceedings, 90, 2 (May),

27 Edwards, Sebastian (1999). "How Effective are Capital Controls?", Journal of Economic Perspectives, 13, 4 (Fall), (2000). "Exchange Rate Regimes, Capital Flows and Crisis Prevention", NBER (December) Eichengreen, Barry and Ricardo Hausmann (1999). "Exchange Rates and Financial Fragility", NBER Working Paper 7418 (November)., Paul Masson, Hugh Bredenkamp, Barry Johnston, Javier Haman, Esteban Jadresic, and Inci Ötker (1998). Exit Strategies: Policy Options for Countries Seekin g Greater Exchange Rate Flexibility, IMF Occasional Paper 168. Fischer, Stanley (1998). "Capital-Account Liberalization and the Role of the IMF", in Should the IMF Pursue Capital-Account Convertibility? Princeton University, International Finance Section, Essays in International Finance, No 207 (May), (2000). "Ecuador and the IMF", in Alberto Alesina and Robert Barro (editors), Currency Unions, forthcoming. Stanford: Hoover Institution Press. Frankel, Jeffrey A. (1999). No Single Currency Regime is Right for All Countries or At All Times, Princeton University, International Finance Section, Essays in International Finance, No. 215 (August). Ghosh, Atish R., Anne-Marie Gulde, Jonathan D. Ostry, and Holger C. Wolf (1997). "Does the Nominal Exchange Rate Regime Matter?", NBER Working Paper 5874 (January). Ghosh, Atish R., Anne-Marie Gulde, and Holger C. Wolf (2000). "Currency Boards: More than a Quick Fix?", Economic Policy 31 (October), Goodhart, Charles and Dirk Schoenmaker (1995). "Should the Functions of Monetary Policy and Bank Supervisor be Separated?", Oxford Economic Papers, 47, Hanke, Steve H. and Kurt Schuler (1994). Currency Boards for Developing Countries. International Center for Economic Growth. San Francisco: ICS Press. Hausmann, Ricardo, Michael Gavin, Carmen Pages-Serra and Ernesto Stein, (1999). "Financial Turmoil and the Choice of Exchange Rate Regime", Inter-American Development Bank, Working Paper 400. Isard, Peter and Hamid Faruqee, eds (1998). Exchange Rate Assessment: Extensions of the Macroeconomic Balance Approach, IMF Occasional Paper 167. Kaplan, Ethan and Dani Rodrik (2000). "Did the Malaysian Capital Controls Work?", Kennedy School of Government (December). Kenen, Peter (2000). "Currency Areas, Policy Domains, and the Institutionalization of Fixed Exchange Rates", Princeon University (April).

28 McKinnon, Ronald and Huw Pill (1999) "Exchange Rate Regimes for Emerging Markets, Moral Hazard, and International Overborrowing," Oxford Review of Economic Policy. Levy-Yeyati, Eduardo and Federico Sturzenegger (2000). "Exchange Rate Regimes and Economic Performance", paper presented at IMF First Annual Research Conference (November). Masson, Paul (2000). "Exchange Rate Regime Transitions", IMF Working Paper, WP/00/134 (July). Mussa, Michael, Paul Masson, Alexander Swoboda, Esteban Jadresic, Paolo Mauro, and Andrew Berg (2000). Exchange Rate Regimes in an Increasingly Integrated World Economy, IMF Occasional Paper 193. Obstfeld, Maurice and Kenneth Rogoff (1995). "The Mirage of Fixed Exchange Rates", Journ al of Economic Perspectives, 9, 4 (Fall), Summers, Lawrence H. (2000). "International Financial Crises: Causes, Prevention, and Cures", American Economic Review, Papers and Proceedings, 90, 2 (May), Williamson, John (2000). Exchange Rate Regimes for Emerging Markets: Reviving the Intermediate Option. Washington, DC: Institute for International Economics (September).