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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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Fischer (2001) classifies those arrangements into three groups: hard pegs (categories [1] and [2], 47 economies in Table 1), intermediate group (categories [3] through [6], 59 economies), and float (categories [7] and [8], 80 economies). As of the end of March 2001, approximately one-third of the world’s economies, presumably developing economies, belonged to the intermediate group, as can be seen in Table 1.

Summers (2000) observes that the sources of recent currency crises are not fiscal deficit and current account crises, but serious banking and financial-sector weakness and short-term capital flows. He points out that fixed exchange rates work poorly under conditions of financial deregulation and free capital mobility. He states the choice of appropriate exchange rate regime means “a move away from the middle ground of pegged but adjustable exchange rates toward the two corner regimes of either flexible exchange rates or a fixed exchange rate supported, if necessary, by a commitment to give up altogether an independent monetary policy” (Summers [2000, p. 8]). Is the bipolar view (also referred to as the “hollowing-out hypothesis” by Eichengreen [1994]) the answer to the choice of exchange rate regime? In the remaining part of this section, we will discuss the pros and cons of this idea.

Fischer (2001) argues that in the last decade there has been a hollowing out of the middle of the distribution of exchange rate regimes, with the share of both hard pegs and floating gaining at the expense of soft pegs (Figure 1). He expects the bipolar view will apply to the emerging market economies. The choice between hard peg and floating depends on the characteristics of the economies, in particular on their inflation history. Hard pegs make sense for economies with a long history of monetary instability or for an economy closely integrated in both capital and current account transactions with another economy.10 Fischer’s view is clear-cut in theory, but what about empirical evidence for the bipolar view?

One may object to the bipolar view based on the classification published by the IMF, especially before 1998, because those classifications might simply reflect legal (de jure) institutional frameworks in the reporting economies.11 Thus, de facto

10. Glick (2001) also shows that capital controls were more frequently employed by economies with intermediate regimes than with either hard pegs or independently floating regimes in 1999. Those economies experiencing greater integration with international capital markets tend to find it difficult to commit to intermediate regimes.

11. The classification system since January 1999 is based on the members’ actual regimes, which may differ from their officially announced arrangements.

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exchange rate regimes based on the working of financial markets or macroeconomic variables might be more appropriate. Studies based on a de facto exchange rate regime give a mixed answer to the bipolar view. Levy-Yeyati and Sturzenegger (2000, 2001) classify economies into four exchange rate regimes using cluster analysis based on three macroeconomic variables.12 According to their analysis, the number of economies classified as “intermediate group” still accounts for more than one-fourth of all economies. Masson (2001) also shows that the intermediate cases will continue to constitute a sizable fraction of actual exchange rate regimes.13 On the other hand, Frankel et al. (2000) add an argument against intermediate regimes based on Chile’s data and on the results of Monte Carlo simulation.

In our view, a weak point of the bipolar view is that there are few economies with hard pegs, especially large ones.14 Exceptions include the euro-area economies, the CFA Franc zone economies, Ecuador, Panama, and Hong Kong, at the time this paper was written. Thus, the next three sections first review a few debates on the management of exchange rate regimes with special attention to examples of the hard pegs listed above to evaluate the bipolar view. Then those sections explore the possibility of future regional currencies in each area.

12. They use monthly percentage changes in the nominal exchange rate, the standard deviation of monthly percentage changes in the exchange rate, and the volatility of reserves. Shambaugh (2001) discusses the problems of coding method by Levy-Yeyati and Sturzenegger (2000) and proposes a new approach of de facto two-way coding system between pegs and non-pegs focusing on the volatility of exchange rates.

13. He computes a transition matrix across exchange rate regimes from the data published by Ghosh et al. (1997) and Levy-Yeyati and Sturzenegger (2000) to obtain his conclusion.

14. Glick (2002) nicely states that “the hard peg pole is narrower than we thought.”

53III. The European Experience

It is well known that one of the economic backgrounds of the European Monetary Union (EMU) was the theory of optimum currency areas. However, according to Dellas and Tavlas (2001), the European Union (EU) economies do not satisfy optimum currency area criteria sufficiently.15 So what lesson about exchange rate regimes in the 21st century can we learn from the European experience? Note that behind the bipolar view lie successive speculative attacks against economies with pegged exchange rates since the EMS crisis in 1992–93.

Thus, in this section, we will review the lessons from the EMS that may apply to future exchange rate regimes. We then move on to problems faced by policymakers in the euro area following the euro’s establishment. Finally, we will discuss the possibility of a future expansion of the euro area.

A. The Way toward the Euro: Past and Present

1. Lessons from the EMS After the collapse of the Bretton Woods system, European economies moved to develop their own arrangements for exchange rate stability. These started with the “snake in the tunnel” and moved on to a more structured EMS in 1979. The EMS was de facto a system in which “capital controls were permitted to allow governments to negotiate realignment while providing them a degree of policy autonomy” (Aldcroft and Oliver [1998]). It experienced 11 episodes of realignment between 1979 and 1987. However, over the years, a code of conduct had been built up as the EMS developed from a mere exchange rate arrangement into a powerful convergence instrument, such as the Basle-Nyborg Agreement, which strengthened intervention in the foreign exchange market. It implied the acceptance of the deutschemark as the anchor of the system (Braga de Macedo et al. [2001]). Differentials in rates of inflation in the EMS economies converged remarkably during the late 1980s, which could be explained by the “credibility hypothesis.” According to this, economies such as those of France, Italy, or the United Kingdom could increase the credibility of their national monetary policies and lower their national expected rates of inflation by pegging their currencies to the deutschemark, which usually recorded a low rate of inflation under a credible monetary policy.

These successful periods did not last long. By July 1990, most EMS member economies had removed capital controls, which had been one of the most important methods of successful monetary management under the EMS.16 The removal of capital controls seemed to be one of the key factors behind the EMS crisis in

15. According to Dellas and Tavlas (2001), among the optimal currency area criteria, the EU economies satisfy only the criteria of openness and trade integration. Note that EMU is just a factor of European integration, which includes European economic integration and European political integration. Thus, the economic and political integration in the EU economies could allow those economies to satisfy the optimum currency area criteria in the future.

16. Wyplosz (2001a) mentions that the conflict between fixed exchange rates and the active use of monetary policy was reconciled through internal financial repression such as quantitative limits on bank credit and ceilings on interest rates in addition to capital controls.

54 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview 1992–93, consistent with the bipolar view. Of course, free capital mobility does not always mean that the peg is subject to attack, as can be seen in the experience of the EMS after the crisis. The acceptance of a stability-oriented policy by member economies that essentially meant mutual regional surveillance, together with central parity within a large band, seemed to improve the credibility of the peg under the single European capital market (Braga de Macedo et al. [2001]).

Moreover, free capital mobility is not the only problem in the EMS. Let us briefly summarize two other internal problems that made it difficult for the EMS economies to defend their band, following Dellas and Tavlas (2001).

First, suppose that a shock occurs in the central economy (Germany) and that the currency of the central economy appreciates against a currency outside the EMS (say, the dollar). Within the EMS, the currencies of the other member economies (such as France or Italy) also must be made to appreciate against the dollar to defend the EMS band, although they have been hit by no shock at all. Dellas and Tavlas (2001) call such a process of transmitting shocks within the central economies to the other member economies the “magnification effect.”17 Second, member economies with relatively high inflation and high nominal interest rates experienced capital inflows and their nominal exchange rates become overvalued against the currencies of low-inflation economies. Such overvaluation encourages more production of non-traded goods, and leads to current account deficits in relatively high-inflation economies. This episode demonstrates that the pegged system has a transition problem.18 Based on those arguments, Dellas and Tavlas (2001) conclude that the experience of the EMS provides evidence that an exchange rate peg nominal anchor contains internal dynamics which make such a regime especially fragile.

2. Issues relevant to a successful single monetary policy The launch of the euro on January 1, 1999 and the circulation of euro-denominated banknotes and coins in January 2002 are two important events demonstrating that the European economies have finally completed the formation of a single currency.

However, a number of “flaws” or “hazards” have been pointed out in the construction or in the working of EMU. Among these problems, Bordo and Jonung (1999) highlight three: (1) the absence of a central lender-of-last-resort (LLR) function and the lack of supervisory authority of the EMU-wide financial system, (2) the absence of central coordination of fiscal policy within EMU, and (3) weak democratic control (accountability) of the European Central Bank (ECB). We will discuss these problems in turn.

17. This process illustrates the overall appreciation of European currencies during German reunification. At that time, the Bundesbank tightened monetary policy during the massive fiscal investment that occurred in the former East Germany, and that policy mix led to the appreciation of the deutschemark. Other member economies maintained exchange rate stability against the deutschemark by tightening their monetary policies at the cost of accepting appreciation against the dollar and the yen.

18. This phenomenon is consistent with the many episodes of realignment in the early 1980s. At that time, rates of inflation in the other EMS economies were higher than that in Germany. But the nominal exchange rates of those other economies’ currencies did not depreciate much within the EMS. As a result, appreciated real exchange rates led to subsequent realignments.

55 a. Maintaining the financial stability of EMU In EMU, it is not the ECB but national central banks (NCBs) that primarily have LLR functions. Bank supervising authorities (NCBs or government agencies), rather than the ECB, are primarily responsible for bank supervision.

The advent of the euro has stimulated the integration of financial markets of member economies. An integrated financial market might spread a large negative shock in one member economy into area-wide financial instability. Obstfeld (1998) pointed out two problems regarding the Maastricht Treaty’s blueprint for safeguarding financial stability.

First, regarding the structure of euro zone prudential supervision, Obstfeld (1998) wondered whether the division of regulatory responsibility among national regulators might be a misguided application of the principle of subsidiarity, because the optimal domain of regulation in an integrated financial market would not be smaller than the market itself. For example, the national regulators may not fully internalize the adverse repercussions of a financial crisis, particularly when the bill for containment arrives at the EMU or EU level. Another concern is that national regulators might favor national institutions or financial centers through lax application of the rules.

Second, regarding the lack of a statutory mandate for the ECB to act as an LLR, Obstfeld (1998) argues that such an arrangement is only consistent with the special features of the German financial system. Those include a relatively low degree of securitization, the dominant position of large universal banks; the high levels of reserves and collateralizable securities that German banks hold, and other features of the domestic payments system.19 However, the euro financial system does not share these structural features of the German system.20 Against this criticism, Padoa-Schioppa (1999) claims that many bank supervision procedures have been harmonized within EMU, and that “there are neither legalcum-institutional, nor organizational, nor intellectual impediments” to operating LLR when an EMU-wide crisis occurs. He concludes, “There is no expectation, at least to my mind, that the division of responsibility... should be abandoned.”21 b. The central coordination of fiscal policy within EMU Is a harmonized single fiscal policy necessary for a monetary union?22 In Europe, the Delors Report of the Committee for the Study of Economic and Monetary Union (1989) emphasizes the necessity of harmonized fiscal policy in EMU.

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