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«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»

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Some discussion of this literature in the paper might have been useful. Some studies find no differences in growth rates across regimes. Others find that countries with pegged rates are more likely to have lower growth. However, the paper on the program here by Edwards and Magendzo (2002) finds that countries with independent currency unions, such as the those in the CFA Franc zone and the Eastern Caribbean Currency Union (ECCU), experienced higher growth.

To resolve such differences in results, it is essential to address a number of methodological issues. What is the appropriate methodology to classify countries by their exchange rate regime? There are a number of different approaches to regime classification. Some classify countries according to de jure self-descriptions given to the IMF. Others look at de facto behavior as evidenced by observed variations in 85 exchange rates. Others take into account movements of other related variables, such as international reserves, interest rates, and parallel rates. None of these approaches is without problems, however. In particular, even if a country’s de facto preferences differ from its officially announced designation, this difference may not be revealed unless the shocks it faces are sufficiently large.

Other methodological issues include: how should one handle possible simultaneity problems—i.e., the possibility that the choice of regime, such as a currency union, may depend endogenously on the expected economic performance. How should one handle the contamination effects of regime collapses on performance comparisons?

In other words, when a pegged regime collapses and a country adopts a floating rate regime, one would like to avoid inappropriately attributing the economic performance effects of the pegged regime in the period after the collapse to the floating regime. How useful are the results for larger countries, since much of the test power in some studies typically comes from small countries in the sample? These issues all need to be addressed when making cross-regime comparisons.

What other criteria are relevant in making regime choices? The optimum currency area (OCA) literature provides a long list of well-known criteria for evaluating the relative desirability of fixed versus flexible exchange rate regimes. It is generally accepted that a country is more likely to benefit, on net, from establishing a hard peg with an anchor country if it trades a lot with the anchor, the economic shocks they face are highly correlated, there is a high degree of labor mobility among them, there exists a federal fiscal mechanism to transfer funds to regions that suffer adverse shocks, and if the exchange rate is needed as a nominal anchor.

Here I would like to make two points: first, as the authors recognize, some country characteristics may be endogenous to the exchange rate regime. For example, the act of fixing to a particular currency may promote greater trade with the anchor country and a greater correlation of shocks over time. This implies that a country that does not initially satisfy OCA criteria when adopting a hard peg may come to do so over time. That is, a country may grow into being a good candidate for a hard peg ex post.

But how quickly such endogenous changes in country characteristics occur is open to question. Much of the evidence of endogeneity between regimes and economic integration is based on cross-section evidence, not time-series evidence.

Consequently, we do not know how long it may take for a currency union to generate large trade effects. It may be quick: trade between West and East Germany grew fourfold within five years of reunification. It may be slow: 10 years after Argentina’s adoption of a currency board with the United States its bilateral trade with that nation was little changed; indeed, the proportion of Argentina’s trade with the United States—less than 15 percent—was little different from New Zealand’s.

Second, the decision to enter into a hard peg is ultimately as much political as it is economic. Clearly, political factors sped up the economic integration of East and West Germany. Clearly, politics played a key role in the formation of the European Monetary Union (EMU). Many would argue that EMU was feasible only as part of a larger political goal of integrating Germany with the rest of Europe. Moreover, the hard pegs of the CFA, ECCU, and Pacific Island countries—which account for 86 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Comment almost two-thirds of the current hard pegs among developing countries—are essentially artifacts of colonial or trustee political relationships. So, if we are looking for criteria to guide us about which countries are the best candidates for hard pegs and currency unions, the role of political factors should not be underestimated.

III. Outlook for Regional Currency Arrangements Let me conclude with my own views of where things are headed. As I said earlier, in my opinion intermediate regimes are not viable in the long run without capital controls. Without capital controls, few developing countries have the prerequisites of strong banking systems, flexible economies, and political stability to sustain an intermediate regime successfully even in the short run.

So, as countries open their capital accounts, most will choose—voluntarily in some cases, involuntarily in others—to move to harder pegs or greater exchange rate flexibility. But I have my doubts about how many hard pegs will emerge outside of Europe. In Europe, harder pegs will be attractive for some Central European countries, as much for political reasons as for economic reasons, particularly if they have a voice in the formulation of monetary policy once they join Europe’s monetary union. In the Americas, harder pegs may be attractive for small economies that trade heavily with the United States, following the example of Ecuador and El Salvador, but I do not see hard pegs in the future of the larger countries.

As for Asia, I also do not see hard pegs as desirable for most countries in the region. A lot of people, including some at this conference, still urge some form of intermediate regime in Asia, involving a common peg to a basket of the dollar, yen, and euro. But I think such a regime would be neither in the interests of most countries in the region, nor would it be easy to implement. Differences in trade patterns across the region complicate agreement on the composition of the basket.

Such a basket, even with a band, would face speculative pressures. There is no natural focal country for the convergence of policies, at least not until Japan escapes from its current economic stagnation. Moreover, there does not yet appear to be the strong political will for deeper economic integration as was the case in Europe.

Consequently, a more flexible rate regime is likely to perform better for most countries in the region.

That is not to say there are no reasons to have less formal kinds of coordination of exchange rate policies among countries in the region, particularly to deal with contagion episodes. In this regard, I recognize that progress in Asia has been made through, for example, the Chiang Mai currency swaps agreement. But the funds potentially available under these arrangements are still small relative to the liquidity of international financial markets. Hence, they represent only one step on what is likely to be a long path if the goal of greater cooperation in the region is to be achieved.

87 References

Edwards, Sebastian, and I. Igal Magendzo, “Independent Currency Unions, Growth, and Inflation,” Monetary and Economic Studies, 20 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2002, pp. 215–232 (this issue).

Fischer, Stanley, “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives, 15 (2), 2001, pp. 3–24.

Glick, Reuven, “Fixed versus Flexible Exchange Rates: Is It Still Possible to Manage in the Middle?” in Gordon de Brouwe, ed. Financial Markets and Policies in East Asia, Routledge Press, 2001, pp. 220–234.

General Discussion

Responding to the comments of the discussants, Hiroshi Fujiki addressed the question of the relation between the choice of exchange rate regimes and capital mobility, and agreed that Reuven Glick’s position was consistent with the experiences of the 1992–93 European Monetary System (EMS) crisis. Fujiki also stated that endogenous factors needed to be taken into consideration in the empirical studies on the choice of appropriate exchange rate regimes, and that this would be a subject for future study. Regarding the choice of exchange rate regimes from the perspective of economic welfare criteria, Akira Otani reiterated the promising aspects of the new openeconomy macroeconomics and agreed with Stefan Gerlach’s comment that it would be necessary to expand this approach in the direction of incorporating imperfections in international financial markets.

Following this discussion, a wide range of general comments were made by other participants concerning such matters as specific regional currency areas and desirable exchange rate regimes.

Regarding the European experience, Fujiki and Otani, and Glick took the position that the elimination of capital controls contributed to the EMS crisis.

Jorge A. Braga de Macedo (OECD Development Centre) and Pierre van der Haegen (European Central Bank) expressed doubts that the removal of capital controls constituted a fundamental cause of the currency crisis, for the following reasons. (1) The crisis was triggered by a major shock generated by German reunification; and (2) after the crisis, in compliance with the convergence criteria and requirements of the Maastricht Treaty, the countries concerned adopted policies that were consistent with stabilizing the exchange rate of the deutschemark.

Subsequently, exchange rates among member countries were extremely stable under conditions of free capital movement.59 Glick responded to these comments as

59. Braga de Macedo stated that, in compliance with the Maastricht Treaty, member countries adopted policies consistent with future monetary union under the provisions of the “Exchange Rate Mechanism (ERM) code of conduct,” and that this contributed to exchange rate stability. For details, see Jorge A. Braga de Macedo, Daniel Cohen, and Helmut Reisen, Don’t Fix, Don’t Float: The Exchange Rate in Emerging Markets, Transition Economies and Developing Countries, Development Centre Studies, Paris: Organisation for Economic Co-operation and Development, 2001. This publication states that the “ERM code of conduct” meant that, in the event of interest rate changes and in crisis management, the fiscal and monetary authorities of the member countries would work in close coordination under the leadership of the Bundesbank, using the deutschemark as the anchor currency for the EMS.

88 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 General Discussion follows. While agreeing that a negative shock affecting the anchor country provided the immediate cause for the EMS crisis, Glick argued that the elimination of capital controls prompted the markets to test the appropriateness of the policy mix adopted by the policy authorities.

Regarding the Asian region, Ismail Alowi (Central Bank of Malaysia) motioned that the global experience showed that when fixed exchange rate regime collapsed, it was not due to the regime itself, but to weaknesses in the economy such as large fiscal and current account deficits and the fragility of the financial and banking systems, concluding that pursuit of an appropriate and consistent policy mix was essential under any exchange rate regime. Han Ming Zhi (The People’s Bank of China) commented that while the Chiang Mai Initiative was a worthy first step, various problems remained to be addressed in the Asian region, including the development and improvement of financial markets. Responding to this statement, Braga de Macedo commented that, in light of the experience of the European Monetary Union (EMU), the Asian countries would need to develop close cooperation and peer pressure in order to advance toward a regional currency area.

Commenting on the impact of hypothetical widespread dollarization in the Americas on the anchor country, Roger W. Ferguson, Jr. (Board of Governors of the Federal Reserve System) noted that explicit institutional requirements for dollarization should be considered.

Responding to the comments of Gerlach on the new open-economy macroeconomics, Maurice Obstfeld noted that future research in this area should be directed toward developing models which incorporate incomplete capital markets.

While agreeing with Glick concerning the endogeneity of optimal currency-area criteria and economic performance, Obstfeld went a step further to note that assessments based on welfare criteria are indispensable when attempting to determine whether it is more desirable for business cycles for a set of countries to be synchronized under a common currency, or for them not to be synchronized by instead adopting floating exchange rate regimes. He emphasized that the new open-economy macroeconomics was useful in comparing maximum attainable utilities of different types of exchange rate regimes.

Regarding large exchange rate fluctuations, Allan H. Meltzer commented that transitory and permanent fluctuations should be treated separately, because only permanent fluctuations have a major impact on terms of trade and resource allocation. Malcolm D.

Knight (Bank of Canada) stated that inflation targeting was effective in restraining excessive exchange rate volatility, because fluctuations resulting from an unanticipated shift in monetary policy would be constrained. Responding to these views, Glick explained that emerging economies were fearful of large exchange rate fluctuations because of the “original sin” of being unable to borrow in their own currencies.60

60. The “original-sin hypothesis” describes a situation faced by most emerging market economies, in which they cannot borrow funds from abroad in their own currency but remain dependent on dollar-denominated short-term bank loans, as occurred even during the period of rapid and global capital movement liberalization of the 1990s. For the original presentation of this hypothesis, see Barry Eichengreen and Ricardo Hausmann, “Exchange Rates and Financial Fragility,” New Challenges for Monetary Policy, a symposium sponsored by the Federal Reserve Bank of Kansas City, 1999, pp. 329–368.

89 Hence, he asserted, when adopting floating exchange rates, in addition to adopting inflation targeting, it is necessary to take steps to resolve “currency mismatches.”61 Knight commented that the choice of exchange rate regimes cannot be made in isolation and must be consistent with other macroeconomic policies. Robert W.

Rankin (Reserve Bank of Australia) commented that when examining the relation between desirable exchange rate regimes and the depth of market liquidity, as well as the degree of sophistication of domestic financial markets, it is necessary to pay due attention to the fact that both are endogenously determined.

The chairperson of the session, Miyako Suda (Bank of Japan), closed the session with the following observations. As a result of growing global interdependence and recent developments in economic theory, a far more complex series of factors must be considered in evaluating exchange rate regimes. It was hoped that this matter would be discussed further in the following sessions.

61. This argument is patterned after Morris Goldstein’s “managed floating plus” position, which calls for the combination of inflation targeting and aggressive measures to reduce currency mismatches (Morris Goldstein, Managed Floating Plus, Washington, D.C.: Institute for International Economics, 2002). Goldstein proposes a variety of measures to limit currency mismatches; these include periodic announcements of the ratio of short-term foreign debt to foreign reserves, the development of deeper capital markets that allow better hedging mechanisms, and a prohibition against government borrowing in foreign currencies.


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