Stephen Grenville: Exchange rate regimes for emerging markets
Speech by Mr Stephen Grenville, Deputy Governor of the Reserve Bank of Australia, to the Economic
Society of Australia, Inc., (New South Wales Branch) Sydney, on 30 October 2000.
* * *
At the outset, I should explain what motivates my interest in this topic. It goes without saying that
none of what I say today implies any dissatisfaction with the Australian exchange rate regime. The
float has worked well in Australia and there is no reason to reassess or reconsider. Today's talk is
intended to be part of a vigorous debate currently going on in the international community about
which exchange rate regime should (and, more specifically, should not) be adopted in emerging
countries, with this particularly aimed at countries which are undergoing financial deregulation. These
countries are being exhorted to adopt exchange rate regimes at the ends of the spectrum - either a pure
free floating rate, or a strongly fixed rate (preferably with institutional backing in the form of a
currency union or even dollarisation).
One argument with superficial attractiveness is that the old regimes failed these countries, and
therefore something else - preferably very different from the old regime - will solve the problem. A
principal purpose of this paper is to argue that the appropriate regime will differ between countries and
perhaps also over time - there are no simple rules and no easy solutions. Whatever regime is chosen, it
has pluses and minuses, and any regime will require careful nurturing and support from other policies.
The crisis countries should learn from their experience, but should not assume that, because one
regime failed, another will be trouble-free. It is certainly true that the countries at the centre of the
Asian crisis - Thailand, Indonesia and Korea - had rates that were de facto soft fixes - a high degree of
stability in the good times, but not any serious institutional defences when they came under pressure.
One clear lesson is that these exchange rate regimes did not perform well in the crisis. Some have also
noted that Hong Kong and Argentina, with hard pegs, were able to withstand the pressure, in the sense
that their exchange rate regimes did not break down. Others have observed that countries such as
China and India were able to maintain parities by virtue of the application of capital controls, so an
equally-vigorous debate on the role of capital controls is intertwined with the debate on regimes. This
paper attempts to draw together this diverse experience.
What have we learnt from the recent crisis?
As a preface to this section, I should note that, as usual, the crisis has been used by various people to
advance their own theories on the way the world works and the way it should work. As with many
debates, the coalitions which form to advocate a particular outcome often have diverse motives, and
not everyone comes from the same starting point or uses the same analytical framework. Any sensible
observer of the crisis understands that there were a variety of causes, and identifying one single cause
is unlikely to move us to a world of perfection. With this preamble, let us look at the immediate and
obvious lessons for exchange rates from the crisis.
• Exchange rates overshoot, resulting in substantial and sustained shifts of real exchange rates
not explicable in terms of fundamentals. Indonesia entered the crisis with its exchange rate
only modestly overvalued, but the rate fell to one-fifth(!) of its pre-crisis value. Markets are
prone to exhibiting a herd mentality and, once an exchange rate starts to move, or a peg is
broken, it can be difficult to limit adjustments to modest amounts.
Contagion is a problem. While markets did discriminate among countries to a degree, this
•
was more noticeable in the longer run than in the short run.
• There has been a lack of players willing to take contrarian foreign exchange positions in
newly-emerging countries. This is a self-reinforcing problem. There are few stabilising
speculators so the exchange rate moves a long way; but because the rate moves a long way,
there are few who are willing to take on the risk of stabilising speculation. This lack of
contrarian position-taking might reflect some relative lack of information about these
economies, which should be straightforward to remedy. But more often the problem is more
deep-seated and the remedy more difficult. Part of the problem here is that the market's view
of exchange rate fundamentals ("the model") is nebulous and fragile. As well, there may be a
lack of policy credibility, which can only be redressed over time.
The transition from regulated to liberalised financial systems is a vulnerable period. Careful
•
sequencing may help, but it is difficult to create the necessary infrastructure quickly.
Massive capital flows (inflows prior to the crisis, and outflows after) were a dominant factor.
•
For example, Thailand experienced inflows equal to 13% of GDP in 1996. Choice of regime
needs to take into consideration not only current account issues but also the greatly increased
mobility of capital and the international integration of financial markets.
Choice of regime
Some high-profile commentators drew from the Asian Crisis experience the conclusion that countries
should opt for either a very "hard" fix or a very free float. "Thus the new language of speculative
attacks, multiple equilibria and moral hazard is in many ways simply a new overlay on an old debate.
And yet, a genuinely new element has recently been thrown into the mix. This is the proposition that
countries are - or should be - moving to the corner solutions. They are said to be opting either, on the
one hand, for full flexibility, or, on the other hand, for rigid institutional commitments to fixed
exchanges, in the form of currency boards or full monetary union with the dollar or euro. It is said that
the intermediate exchange rate regimes are no longer feasible - the target zones, crawls, basket pegs,
and pegs-adjustable-under-an-implicit-escape-clause - are going the way of the dinosaur."
(Frankel et al 2000). The Economist (1999, pp 15-16) put the same point more briefly: "Most
academics now believe that only radical solutions will work: either currencies must float freely, or
they must be tightly tied (through a currency board or, even better, currency union)."
The rationale is rather different from the traditional textbook arguments about the choice of exchange
rate regime.1 The new argument is a response to the volatility of capital flows and the threat of
self-fulfilling speculative attacks: both strong fixes and free floats are immune from attack, at least in a
definitional sense. At the fixed end, the emphasis is on credibility, so irrevocability is an important
element of the fix - hence the interest in currency boards and the ultimate fix - dollarisation. At the
other end of the spectrum, the pure float also has the attraction of its ability to withstand an attack (or
large volatile capital flows) without the exchange rate regime collapsing.
Considering the depth and sophistication of traditional arguments, pro and con, for a wide range of
different regimes, the new slant on this seems at first sight rather superficial, not far from a truism (if
an attack on a fixed rate succeeds, the "fix" wasn't strong enough:2 and an attack on a floating rate
leaves it immune only to the extent that the authorities can put up with whatever movement in the rate
occurs). If this new slant on choice of regime is to make a useful contribution to the debate, it has to be
seen as another layer on top of the other (still valid) arguments about regimes and has to be seen to
address, more specifically, why the perceived advantages of intermediate regimes ("the middle of the
spectrum") are overridden.
One flawed argument in support of the "disappearing middle" of the spectrum goes under the
shorthand of the "Impossible Trinity": it is not possible to have, simultaneously, an open capital
market, a fixed exchange rate, and an independent monetary policy. While the trinity may indeed be
impossible, it relates only to a fixed rate and therefore says nothing about the possibility of having
intermediate positions - a flexible but managed rate, a reasonable degree of monetary independence,
and an open capital account. For that matter, the criticisms arising from the Asian Crisis could be
properly directed only at the "fixed but adjustable" segment of the spectrum, where reserves were
spent in futile defence of a rate which markets no longer believed was viable. Even here, the argument
is far from clear-cut: Indonesia did not defend its exchange rate when it came under pressure, and yet
suffered the greatest fall (and the most serious consequences from this fall).
The valid elements of the case against a "fixed but adjustable" regime are two-fold:
• that the fixed element may have encouraged borrowers to be too confident in taking out
foreign-exchange-denominated loans;
• that when pressure came on the exchange rate, it created the same incentives which drive
bank runs - the one-way bet which makes rational investors close out their position ahead of
a possible collapse, and creates the incentive on the part of the authorities to defend the
status quo to avoid triggering the run.
The prescription seems easy, but these "ends of the spectrum" may not be comfortable or easy to
maintain. Only a limited number of countries will find the policy constraints of a currency board or the
loss of sovereignty involved in dollarisation politically palatable. Smaller countries with a suitable
pegging partner may find this an acceptable and viable solution, but - leaving aside the special case of
the euro - medium-sized countries will only be attracted to a hard fix if there are very compelling
constraints on their choice, and they will find the degree of adaptation needed in the domestic
economy can be painful indeed. Where relative prices cannot change through exchange rate
adjustment, domestic prices must adapt.3 Even super-flexible Hong Kong has found this hard, with
GDP falls as large as Korea's during the Asian crisis. Argentina's choice of a strong fix may well be
correct policy, but it is clearly painful.4
If the end of the spectrum does not facilitate the sorts of adjustment which the underlying
fixed
fundamental may require, then the free float end of the spectrum may well deliver much more
variability than the fundamentals require.
Views on how a free float would work in practice have changed over the past thirty years, in the light
of experience. Early protagonists were confident that floating exchange rates would be stable and
would reflect fundamentals. Harry Johnson (1973, p 208) assured us that: "A freely flexible exchange
rate would tend to remain constant so long as underlying economic conditions (including government
policies) remain constant; random deviations from the equilibrium level would be limited by the
activities of speculators."5 Friedman (1953) believed: "... instability of exchange rates is a symptom of
instability in the underlying economic structure ... a flexible exchange rate need not be an unstable
exchange rate. If it is, it is primarily because there is underlying instability in the economic
conditions ...'.
In practice, the general experience might be summed up this way:
• nominal exchange rates are, unaccountably, closely correlated with real exchange rates;6
• the switch from fixed to floating rates has produced much more variability ("an order of
magnitude more"), even when fundamentals are not more variable (Flood and Rose 1999);
• fundamentals cannot explain the behaviour of the exchange rate over a short/medium-term
horizon;7
exchange rates have at times exhibited long-lived swings, with no apparent changes in
•
fundamentals significant enough to justify them. The US dollar appreciated by about 90%
against the Deutsche mark in the first half of the 1980s, only to completely unwind this
appreciation by 1988. The yen appreciated by about 75% against the US dollar in the first
half of the 1990s, and unwound this appreciation by 1998.
As a result of this experience, a textbook free float with interest rates set exclusively for the needs of
the domestic economy (ie "benign neglect") is out of favour. The exchange rate is routinely a factor in
setting interest rates. Many countries intervene (if only occasionally) in foreign exchange markets, and
when this is done with finesse and sensibly (ie not to defend a particular exchange rate), it has often
been helpful.8
The intrinsic problems of exchange rates in emerging countries
If all this produces volatility and misalignment in developed countries' exchange rates, how much
more serious is it for which have:
emerging countries
• much less well-defined trade-based fundamentals;
• no long historical experience of market-determined exchange rates;
rapidly evolving production structures;
•
• few Friedmanite stabilising speculators;
• much larger and more volatile capital flows, in relation to the size of their domestic capital
markets and economies more generally.
On top of this, we have the evidence from Hausmann et al (1999) that those Latin American countries
which embraced floating during the 1990s experienced substantially larger changes in interest rates
6
See Cooper (1999, p 16).
7
The classic reference, Meese and Rogoff (1983), showed that existing exchange rate models based on economic
fundamentals could not reliably out-predict the naïve alternative of a "no-change" forecast for year-to-year changes in
major-industrial-country exchange rates. Some more recent models can out-predict a "no-change" forecast (for example,
MacDonald and Taylor 1993) but the basic empirical fact remains largely intact. No-one has yet been able to uncover
macroeconomic fundamentals that explain more than a modest fraction of year-to-year changes in industrial-country
floating exchange rates. Frankel and Rose (1995, p 1707) summarise the dismal state of exchange rate empirical research:
"... the case for macroeconomic determinants of exchange rates is in a sorry state. With the exception of some
significance in bits of statistical innovation and announcements at very short horizons, and some hazy predictive power at
long horizons, there is little support for standard macroeconomic models". Flood and Rose (1999) find that the switch to
a floating rate produces much more variability, even if the fundamentals are no more variable: "The policy switch
between fixed and flexible exchange rates entails an essential shift in market structure across regimes ... Expectations
are policy-dependent." (p F668).
8
It is not the purpose of this paper to address the issue of stability among the G3 currencies, but it might be noted that
greater stability would clearly have been very helpful for the other countries. When the yen moved from 80 yen per dollar
in April 1995 to almost 150 in the middle of 1998, this was clearly quite disruptive for countries with liabilities
denominated in either dollar or yen. A case can be made that a trigger or catalyst for some of the crisis has, in fact, been
movements in foreign exchange rates or interest rates - with the tightening of US interest rates in early 1994 being a
factor in Mexico, and the depreciation of the yen after April 1995 being a factor in causing yen-denominated borrowers to
focus on their yen-carry borrowing strategies.
than fixed-rate countries (ie they were not, in fact, able to direct monetary policy to the needs of the
domestic economy, but had to use it to defend their exchange rates).
But the main problem faced by emerging countries which chose a free float is how the rate would
behave in the face of the large and volatile capital flows which these countries experienced in the
1990s. In due course, these flows seem likely to resume for many, if not all, of the countries which
experienced them in the 1990s. They are driven by two powerful factors. First, the desire for
diversification on the part of the managers of the huge stock of investment funds in America and
Europe, whose weight of foreign assets is well below the theoretical desideratum. Secondly, by the
intrinsically high profit prospects in the Asian emerging countries (more on this later).
It is worthwhile spending some time to see just how difficult a problem this is. In standard versions of
the exchange rate story, the real exchange rate is determined by productivity developments in the real
economy, and capital flows tend to play a rather secondary role. They are often treated, essentially, as
a residual. Implicitly, there is a ready supply of world capital, so that the current account is determined
by a country's saving/investment balance, and the capital account is a residual to fund this. There is
also a presumption that there is a ready supply of stabilising speculators, so any significant departures
from fundamentals will be ironed out promptly. The standard model for incorporating capital flows
into the analysis is the portfolio balance view, where the main action is with interest differentials. With
some interest differential in place (usually reflecting differing cyclical positions), enough capital flows
to the country to push up the exchange rate so that expected returns are equalised internationally
(risk-adjusted, of course) by the prospect of a subsequent reversal of the exchange rate. The higher
exchange rate helps to open up a current account deficit, which provides the real transfer counterpart
of the financial flows.
But if we try to apply this to the emerging countries, the fit is not good. Perhaps most fundamentally,
the countries which received huge capital inflows in the first half of the 1990s offered high interest
rates (real and nominal), not as a temporary cyclical policy response to the phase of the cycle, but on a
continuing basis. While these countries are making the transition towards the technological frontier, it
is quite likely that higher returns will be available to capital, so a real interest rate differential will
persist over the medium term - decades rather than years. Capital inflow cannot immediately reduce
this interest differential. In the meantime, portfolio equilibrium could, in theory, be maintained by the
real exchange rate being bid up, so that the higher domestic interest rate is balanced by the prospect of
10
subsequent depreciation.9,
How should the exchange rate behave in these circumstances? Real interest differentials of, say, 3%
might persist for a decade or more. If these numbers are realistic, the portfolio balance model would
suggest that the exchange rate has to appreciate initially by some 30% (and will appear seriously and
persistently uncompetitive for trade in goods and services), before depreciating by 3% per year over
the following decade. So the potential swings in real exchange rates, even if well-behaved in terms of
the model, are much greater for emerging markets. Add to this some extrapolative expectations, some
herding, and above all a risk premium which varies with the latest wave of euphoria or pessimism, and
the potential both for volatility, and for significant and sustained misalignment - in both directions - is
clear. It seems unlikely, to say the least, that an exchange rate could follow this portfolio-balance path
of appreciation followed by depreciation without the market balking at the large shifts and the
overvaluation during the long transition.
Is it not surprising, in such a world, that countries have sought to limit the extent of the swings
(misalignments). They have sought to resist the appreciations of the exchange rate during the periods
of large capital inflow partly because of an intuition (which gains some support from the Japanese
experiences in the 1950s and 1960s) that strong international competitiveness provided beneficial
price signals for the most dynamic sector of the economy - tradeables, especially exports. Elements of
old-fashioned mercantalism may be present also.
Perhaps more important still, the large foreign capital inflow creates a destabilising feedback loop
while the inflow is strong, the rising exchange rate reduces the cost of borrowing in foreign currency,
and encourages more borrowing. At the first sign of some weakness in inflow or the exchange rate,
domestic borrowers (including, sometimes, banks) are exposed to greater credit risk, and their lenders
(understandably) will want to withdraw funding. This has many of the characteristics of a domestic
bank run. If confidence could be maintained (in this case, in the stability of the exchange rate), then
the withdrawal of funds will not occur. If confidence weakens, the process is self-reinforcing.
This self-reinforcing instability cannot be easily removed. Some have suggested hedging as the
answer. There is, first, the question of whether the country as a whole can hedge its foreign exchange
risk. While an individual can shift the risk to another party, a country in aggregate can only hedge its
risk if it can persuade foreigners to take on the foreign exchange risk - in effect, lend in the domestic
currency. Even if this could be achieved, one party in foreign capital flow transactions (either the
borrower or the lender) will be exposed to foreign-currency risk, and will have the incentive to unwind
the transaction in the face of a threat to the exchange rate. In this rather unstable world, it is hardly
surprising that countries have resisted the upward pressure on exchange rates that accompanies big
capital inflows, because they feel (with some justification) that it makes them vulnerable to later sharp
depreciation.
When, after the crisis, many commentators attribute the crisis to overvalued exchange rates, and others
urge these countries to hold reserves equal to their short-term debt (the so-called Guidotti Rule), is it
surprising that authorities intuitively feel justified in resisting appreciations? But if the correct lessons
are to be taken from the crisis, then those countries which do not have strong reasons to go to a hard
fix should move decisively away from "fixed-but-adjustable", to adopt a version of what has become
widely-used best practice: allowing the market to determine the rate, leaving considerable volatility
(ie not leaning against the wind through frequent intervention), and even when the rate moves
significantly away from what are judged to be the "fundamentals", being prepared to put up with this,
and stay the resort to intervention, until the case is overwhelming and the prospect of success good.
Interest rate changes in support of the exchange rate are a legitimate part of this regime, while
acknowledging that feasible interest rate settings may not be enough to counter extreme market
pessimism. This is clearly distinct from the totally passive position of a free float ("benign neglect"),
but it is what is generally done in most developed countries. And, most importantly, it is a long way
from the day-by-day activism that has been discredited by the crisis.
Unless we take into account why countries have a "fear of floating", and have often gravitated to soft
fixes in the face of capital inflows, we will be in no position to provide persuasive arguments for the
adoption of greater flexibility.
Perhaps the basis of persuasion might be three-fold:
• that some flexibility will be helpful in absorbing the capital inflow, in buffering external
shocks, and responding to the changing productive capacity of their economies;
• that this flexibility (aka short-term volatility) may inhibit some short-term flows, by serving
as a constant reminder that exchange rate volatility can outweigh the interest-rate advantage
of foreign-currency borrowings;11
• allowing (even encouraging) a fair degree of volatility around a real exchange rate which is
stable over time (or moves only slowly, in response to changing fundamentals) provides the
opportunity for the authorities to have the best of flexibility, while leaving open the
possibility of intervention (both via interest rates and directly in foreign exchange markets)
when the rate has already moved quite some distance away from the fundamentals. There are
obviously difficult practical issues regarding the operation of intervention, but the intuitive
idea is straight-forward enough - the further the actual exchange rate has departed from the
equilibrium, the more damage the misalignment will do; the more confident the authorities
can be that they will be acting as profitable stabilising speculators (buying cheap and selling
dear); and the greater likelihood of success of any intervention on the part of the authorities
(see Volcker (1995)).
In short, there is scope for emerging economies to operate flexible exchange rate regimes without
them having to adopt a textbook type of pure float. Indeed, it would be odd if the international debate
urged emerging markets to adopt more pure forms of floating than the industrial countries have been
able to sustain, especially when the conditions necessary for a successful pure float are less likely to be
present in such economies. Even this strategy will be uncomfortable, and is not guaranteed to succeed.
Large reserves and uncomfortable interest rates might be needed to mount an effective defence, and it
will be tempting to mount this defence too early (not to allow enough flex).
If a concrete example is needed to illustrate the point, Singapore provides it. It was, arguably, the most
successful country exposed to the full force of the crisis, with a managed exchange rate (managed both
in the sense of intervention and through well-designed active capital account policies) (see Lee Hsien
Loong (2000)).
Back-up or support for the exchange rate regime
What more could be done by emerging markets to enhance the possibility of a successful exchange
rate regime? If we accept that one of the central factors presenting pressures on exchange rate regimes
in emerging markets is large and volatile capital flows, then the obvious issue is whether measures can
be taken to reduce the size and volatility of the flows.
The first possibility here is capital controls. Mere mention of this possibility creates deep rifts in the
debate, with views strongly held and a fair bit of heat generated in the process. The process of
transition (financial deregulation) is tricky and time-consuming. Perhaps the common-sense way to
approach this is to accept the possibility that Chilean-style controls (taxes on short-term inflows) may
be useful for some countries during the transition, but not too much should be expected of them (see
the conclusions on Chile itself, which suggest that the controls managed to lengthen the maturity of
the debt, without being able to prevent the exchange rate from appreciating during the phase of capital
inflow) (see Edwards (1998)).12 It may also be useful to adopt the techniques used successfully by
Singapore (and now others) to limit the ability of domestic banks to lend to foreigners in domestic
currency, thus making it much harder for foreign speculators to take large short positions on the
currency.
Other than these specific types of capital control, there are a set of issues which can be put in terms of
prudential supervision, rather than capital controls. The sorts of prudential controls which might be
used are to limit the opportunities for residents to borrow in foreign currency (ie to prevent a repeat of
the Bangkok International Banking Facility) and to monitor them when they do; and to keep very tight
(indeed, unashamedly intrusive) constraints on banks' ability to have open foreign exchange positions
or indirect exposure through foreign exchange loans. The brief lesson here is that emerging countries
should be very ready to put on tough prudential controls, and should ignore those who claim (as
happened in Australia during the 1980s) that such prudential controls are "re-regulation by the back
door". The doctrinal protagonists of free markets (usually arguing their own self-interest above all)
must not be allowed to intimidate regulatory authorities into ignoring the case for "rules of the game".
On a wider canvas, the emerging countries should press forward with the efforts to put in place
best-practice accounting, legal and corporate systems and regulations. The quality of credit and
investment standards, and the strength of management of corporate risks and balance sheets will
determine how closely capital flows match fundamental investment opportunities. This will determine
how effectively a country captures the benefits of access to world capital markets. Paradoxically,
marked improvement in these areas may well encourage even greater inflows: but it should, at least,
lessen the likelihood of sudden reversals of capital.
A tentative operational classification
Countries might be categorised this way:
(a) Those whose size or market development justify floating (ie those who will want to have an
independent monetary policy, and have the institutions to make this feasible). While credible
monetary and fiscal policy will contribute to exchange rate stability, even these countries
will, at times, find that exchange rates move too far relative to fundamentals. There may be a
legitimate role for intervention in these circumstances, but it should be used sparingly to
have the desired impact upon expectations and the behaviour of market participants. In a
flexible rate regime, what is the appropriate nominal anchor to pin down market expectations
(eg an inflation target)?
(b) Those in transition to this state. While accepting the advantages of flexibility, these countries
may want a greater degree of fixity for a time, to help anchor expectations where these are
fragile. These countries may reinforce their exchange rate stability by policies that reduce the
attractiveness and the potentially harmful effects of short-term, easily-reversible capital
flows. Countries in these categories might need to focus on systems that encourage
long-term financing and on maintaining stable current account deficits. These countries may
want to contemplate Chilean-style capital controls (price-based aimed at short-term flows)
and to moderate the pace of financial liberalisation, to keep in step with the pace of
development of financial infrastructure. Adoption of sound and consistent economic policies
may gradually build credibility, but the economy may remain vulnerable during this building
process. Financial infrastructure will develop and gain depth over time. As this happens and
markets gain knowledge of and confidence in the regime, exchange rates should become less
vulnerable and less in need of defensive capital controls. In the meantime, countries should
be ready to move quickly away from defence of an unsustainable rate (which obviously
requires fine judgment about "sustainability"). Allowing exchange rate movement (even if
excessive) will, generally, be preferable to exhausting foreign exchange reserves defending a
particular level of the exchange rate.
(c) Those countries where the case for a fixed rate is compelling might want to consider the rival
merits of some form of strong policy commitment - a currency board or dollarisation. This
would include small countries with a similar economic structure to the potential anchor
country; countries (including larger countries) with a high degree of economic integration,
measured by trade or investment flows; or those with a history of poor economic
management and currency crises, where governments cannot borrow long-term domestically,
or in domestic currency offshore. For many small, and typically open, countries, the cost of
an independent monetary policy will often be greater than the stabilising benefit of a flexible
exchange rate. But there are costs, too, in these strongly fixed systems - if lender of last
resort is to be provided, it would be a fiscal rather than central bank matter; and dollarisation
may imply loss of seigniorage. If a hard fix is elected, what is the most appropriate anchor
currency?
Conclusion
The Harry Johnson and Milton Friedman quotes cited above now seem touchingly naïve, or at best
outdated advocacy, overtaken by the experience of three decades of floating rates. Flexible rates have
turned out to flex more than expected. Developed countries have learned to live successfully with this,
but it is harder going for emerging countries with big capital flows. The best-practice regime
commonly used in developed countries allows wide latitude for the market to set the rate, supported by
occasional intervention and rather more frequent help