Fear of Floating or Fear of Flying: Exchange Rate Policy in the New Millenium

Eduardo Levy Yeyati The World Bank & Universidad Torcuato Di Tella December, 2006 1

Storyboard

 The basics: The debate post-Bretton Woods  The tradeoff: Exchange rate regimes and the real economy  The evidence: Regimes in the 2000s  The FIT (float + inflation targeting) paradigm: natural evolution or fad?

 Fear of flying: building a case for a proactive exchange rate policy

The basics



The real view (‘70s)

 Trade (and welfare) gains vis à vis users of the peg currency vs. loss of the exchange rate as a shock absorber in the presence of nominal rigidities.

  Pro peg  Openness, propensity to trade, trade concentration Pro float  Incidence of real shocks

The basics



The political view (‘80s)

  Bands, “tablitas” & other soft species: Exchange rate anchors as a “policy crutch” to compensate for the lack of monetary credibility or political power Pro peg  high inflation, weak governments

The basics



The financial view (‘90s)

  The trilemma: as the world integrates, countries have to choose between monetary autonomy & a stable ER The bipolar view: Exchange rate policy in emerging economies become more vulnerable to the limits imposed by the trilemma: hard peg or float  The unipolar view: Balance sheet effects due to currency mismatches limit the scope for expansionary devaluations  Hard pegs

The tradeoff



Oversimplifying:

 Fix vs. flex  Enhanced monetary & fiscal discipline (lower inflation) at the cost of greater sensitivity to real shocks & output volatility…   …except under FD (contractionary devaluations) Is this theoretical tradeoff validated by the evidence?

 Yes

The tradeoff



Preliminary evaluation:

  Pegs contribute to lower inflation expectations… …at the cost of greater output volatility…

Regimes & output volatility

[g* j – g ] Δtt_pos + Δtt*pos_1 Δtt_neg + Δtt_neg_1 neg - pos Obs t-1, j Dep. Var.: Change in growth rate Flexible 0.926*** (0.039) 0.059*** [7.99] 0.078** [5.99] 0.019 [0.24] Intermediate 0.974*** (0.043) 0.025 [0.92] 0.138*** [20.42] 0.113*** [6.82] Peg 0.803*** (0.033) 0.091*** [25.30] 0.174*** [64.79] 0.083*** [7.16] 301 326 714 Source: Edwards - LY (2005)

The tradeoff



Preliminary evaluation:

   Pegs contribute to lower inflation expectations… …at the cost of greater output volatility… …and slower growth

Regimes & growth

Peg (%) -1.89** (0.77) LYS(avg) Obs. R 2 Dep. Var.: growth Period averages (1974-1999) 5-year averages (1976-2000) 73 0.522 -1.13** (0.47) 73 0.523 -1.88*** (0.70) 299 0.210 Source: LYS (2003)

The tradeoff



Preliminary evaluation:

   Pegs contribute to lower inflation expectations… …at the cost of greater output volatility… …and lower growth





Balance sheet effects

Subdued inflation fears  dominate  Float  Under FD  Threshold floats Volatility concerns 

The bipolar view after Argentina

Argentina: Fiscal (in)discipline

10% 8% Lecop Domestic market, voluntary debt International market, voluntary debt International financial institutions Privatizations and other capital income 6% 4% 2% 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: De la Torre-Schmukler-LY (2002)

Argentina: Monetary (in)discipline

200 175 150 Real cash in circulation (Left scale) Real cash and quasi-monies in circulation (Left scale) Nominal exchange rate (Right scale) 4.00

3.50

3.00

125 100 75 50 25 0.50

0 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 0.00

Jul-02 2.50

2.00

1.50

1.00

Source: De la Torre-Schmukler-LY (2002)

The bipolar view after Argentina

 Lack of external discipline by private markets Hard pegs do not lead to fiscal discipline   Fiscal dominance  monetary discipline  Hard pegs do not lead to Is de jure dollarization hard enough?

Where do we stand?

 Pegs are

passé

 In most cases, inefficient short-term substitute for credibility  Hard pegs failed the test in Argentina  Learning to live with BS effects  The (dynamic) scope for countercyclical exchange rate policy  The double D: Domestication and de-dollarization of sovereign debt  A unipolar view in reverse?

Exchange rate regimes in the 2000s: Classification

• Key criterion: ER variability relative to forex intervention • The intervention dimension is key to characterized exchange rate policy (as opposed to the evolution of exchange rates) and its consequences

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

De facto regimes over the years: Distribution

78.23% 61.29% 60.74% 60.63% 8.06% 19.35% 14.72% 16.25% 13.71% 19.35% 24.54% 23.13% Fix Int er m 1980 1990 2000 2004 Float Source: LYS (2006)

Emerging LATAM: A FIT paradigm?

60% 50% 41.67% 41.67% 40% 30% 33.33% 33.33% 33.33% 25.00% 25.00% 50.00% 20% 16.67% 10% 0% Fix Int er m 1991 2000 2004 Float Source: LYS (2006)

The FIT paradigm

 N atural evolution or this year’s model?

 Less than a paradigm, more than a fad   Negative experience with alternative options Inflation awareness  CB autonomy, fiscal restraint  Decline in inflation –and dollar indexation– tilts the balance towards more flexibility  Inflation targets substitute for ER anchors  Still far from the benign neglect

The comeback of exchange rate policy?

 Mercantilist interventions as a substitute for protection  Less specific than subsidies  Less prone to mismanagement & corruption  Fear of floating or fear of flying?

 Invertion of the ER anchor problem: sustaining an undervalued currency   Instead of amplified recessions due to price rigidities… …inflationary expansions fueled by positive real shocks.

 Does it work? How?

Fear of flying: A characterization

• Fear of floating’s underlying fears: – Contractionary devaluations (due to BS effects) and currency and debt crisis propensity – Dollar pricing, pass-through and inflation • Fear of flying: Leaning against the appreciation wind – Intervention to strenthen the demand for the foreign currency, to avoid/mitigate appreciation pressures

Fear of flying over time (intermediates)

Source: LYS (2006)

Fear of flying over time (non-floats)

Source: LYS (2006)

…to avoid/mitigate appreciation pressures

Variable Dependent variable: Log Real Exchange Rate (t) Average (t to t+2) Annual average of int. Index (t) Annual average of int. Index (t-1) Annual average of int. Index (t-2) 0.467*** (0.207) 0.504*** (0.216) -0.063

(0.224) 0.163

(0.187) Annual average of int. Index, (average over t to t+2) 0.395** R-squared 0.993

0.993

Additional controls: country and time FE, terms of trade, GDP of trade partners, net inflows.

(0.433) 0.993

Source: LYS (2006)

Real Exchange Rate Plot Source: LYS (2006) -.2

-.1

0 e( ind_int_avg | X ) coef = .46681983, (robust) se = .20742027, t = 2.25

.1

.2

PER SY R PER GNB ECU MDG PER SY R MDG BOL URY MOZ NGA MDG SV N MEX GAB SLV NGA ZMB URY ARG IDN PHL NGA BRA BFA ECU SA U GAB SDN NGA PER SLV NGA VEN HTI MOZ BEN MEX PRY SY R SLV PER ARG ARG MLI IND IND EGY LTU DOM DMA VCT VCT PRY POL NGA HTI MLI MLI MAR DMA TGO POL IND BFA HTI NGA NGA ETH NGA RWA MLI ZAF BOL VCT IDN VCT PER DOM BOL NGA NGA MEX TTO SV N SWZ BRA NGA IDN BOL ZWE NGA URY ZWE TTO KNA GAB HND MDG MDG MWI MUS BRA UGA URY ECU NGA ZMB ARG GNB BRA

Does it work?

(t+1) D GDP BK Trend BK Cycle (avg, t+1 to t+3) Annual average of int. Index (t) 16.207*** (3.098) ∆(foreign_assets/M2) (t) 3.212*** (1.047) ∆(foreign_assets/M2) (t-3 to t) R-squared 0.287

0.2780

9.394*** 6.652*** 5.192*** (2.521) 0.285

(1.613) 0.405

(1.265) 0.598

1.638** (0.818) 0.111

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2 Additional controls: country and time FE, terms of trade shocks, growth of pop., growth of trade partners, net inflows.

Source: LYS (2006)

Does it work?

Growth Trend Cycle -.2

-8.327e-17 .2

e( delta_ratio_res_m2_3ant | X ) coef = 6.6519224, (robust) se = 1.613162, t = 4.12

.4

-.2

-8.327e-17 .2

e( delta_ratio_res_m2_3ant | X ) coef = 5.1922213, (robust) se = 1.2649193, t = 4.1

.4

-.2

-8.327e-17 .2

e( delta_ratio_res_m2_3ant | X ) coef = 1.6387782, (robust) se = .81826191, t = 2 .4

Source: LYS (2006)

How?

∆ Import ∆ Export ∆ (foreign_assets/M2) (t-3 to t) R-squared Output 17.917*** (3.190) 0.9210

Volume 0.151** (0.062) 0.351

Output (avg. t+1 to t+3) 14.780*** (3.142) 0.920

Volume -0.012

(0.044) 0.332

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2. Additional controls: country and time FE, ToT shocks, pop. growth., growth of trade partners, net inflows.

Source: LYS (2006)

How?

Variable ∆(foreign_assets/M2) (t-3 to t) R-squared ∆ Gross domestic Savings 0.825

∆ Gross domestic Investment 8.766*** (2.691) (t+1 to t+3) 10.208*** -2.156

0.744

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2.

∆Log(ToT): Change of logarithm of terms of trade.

Source: LYS (2006)

Savings & investment

-.2

0 .2

e( delta_ratio_res_m2_3ant | X ) coef = 8.7655095, (robust) se = 2.6906957, t = 3.26

.4

-.2

-8.327e-17 .2

e( delta_ratio_res_m2_3ant | X ) coef = 10.229713, (robust) se = 2.1584691, t = 4.74

.4

Source: LYS (2006)

Taking stock

 Dedollarization and debt reduction reduce the incidence of capital reversals  Soft FIT paradigm replaces the ER as nominal anchor  Fear of flying is an increasingly popular contender to drive domestic saving & investment (but not so much exports)  The exchange rate debate appears to have gone full circle to the issues of the 1970s

Thank you

Fear of Floating or Fear of Flying: Exchange Rate Policy in the New Millenium

Eduardo Levy Yeyati The World Bank & Universidad Di Tella December, 2006 33

Balance sheet effects & crisis propensity

Logit model - Dependent variable: Crisis dummy D er FL/FA dollar FL/FA * D er dollar * D er constant Observations Std. crisis controls Institutions, SS & CC Total effect (F-tests) dollar FL/FA D er

0.588***

(0.158)

0.000***

(0.000)

0.745**

(0.348)

-3.555***

(0.292) 1104

-0.829

(0.706)

0.003**

(0.001)

0.674*

(0.359)

0.072**

(0.031)

1.310*

(0.695)

-3.493***

(0.300) 1104 5.77** 5.27** 0.30

-0.610

(1.128)

0.005**

(0.002)

0.676

(0.416)

0.101**

(0.046)

2.027*

(1.049)

-2.455***

(0.529) 535 Yes 7.10*** 4.86** 3.94*

-2.321

(1.552)

0.007

(0.005)

0.411

(0.448)

0.146

(0.095)

3.196**

(1.335)

-2.912***

(0.496) 483 Yes Yes 7.11*** 2.33 1.15 Source: LY (2006)

Balance sheet effects & crisis propensity

100% Controlling for deposit dollarization ratios Low dollarization High dollarization 80% 60% 40% 20% 0% -2.1

-1.8

-1.4

-1.1

-0.7

-0.3

0.0

0.4

0.8

1.1

1.5

1.9

2.2

Exchange rate depreciation 2.6

3.0

3.3

3.7

4.1

4.4

4.8

5.2

De facto regimes over the years: Classification

  Exchange rate volatility (  e ): average of the absolute value of monthly changes in the exchange rate Volatility of exchange rate changes (  D e ): standard deviation of monthly changes in the exchange rate  Volatility of reserves (  R ): average of the absolute value of monthly changes in international reserves relative to the monetary base of the previous month (both denominated in US dollars)

De facto regimes over the years: Classification

Regime



e Float

Low Intermediate Med

Fix

High  D

e

Low Med Low 

R

High Med Low