Each member country of the International Monetary Fund collaborates with the IMF and other members to “assure orderly exchange arrangements and promote a stable system of exchange rates,” recognizing that the essential purpose of the international monetary system is to facilitate the exchange of goods, services, and capital among countries, and to sustain sound economic growth, thus fostering economic and financial stability.1
This paper reviews the stability of the overall system of exchange rates. To focus the review, it is useful to consider three elements that might contribute to a stable system as defined above. First, individual countries’ choice of exchange rate regime should help them achieve their domestic macroeconomic goals, such as price stability and sustained output growth. Second, it should facilitate the country’s interaction with the rest of the system, allowing smooth adjustment to external imbalances and facilitating cross-border flows of goods and capital. Third, the system as a whole should be stable, which requires all IMF member countries, including large players (whose currencies often serve as systemic anchors) and individual countries whose aggregate behavior may be systemically important, to contribute to the stability of the overall system.
Previous studies on exchange rate regimes (Mussa and others, 2000; Rogoff and others, 2004) examined one or another of these aspects—but not all of them together. Mussa and others (2000) argued that advanced economies had (or were headed toward) either hard pegs or pure floats, and that emerging market (and eventually, developing) countries should also go to either end of the bipolar spectrum, mainly to avoid crises. Rogoff and others (2004) focused more narrowly on growth and inflation performance—replacing the de jure classification of regimes with its own de facto measure. Although it found some benefits of pegging for developing countries, it argued that pegged regimes brought few benefits for emerging market economies (EMEs) in terms of inflation or growth performance, and some costs in terms of greater susceptibility to crisis; the study therefore advised EMEs to move toward greater exchange rate flexibility.
Since these studies were conducted, there have been important developments on the international monetary landscape, including the collapse of Argentina’s currency board in 2002, which may have reduced the attractiveness of the hard end of the bipolar spectrum; the large buildup in precautionary reserves in many EMEs and the potential for a further buildup as a reaction to the global financial crisis; and the older problem of global imbalances, which continues to put the global system at risk of a sudden unwinding. These developments suggest that a reexamination of macroeconomic performance under alternative exchange rate regimes, and a fresh review of the systemic stability issues, would be not only timely but also central to improving policy advice to IMF member countries. To this end, this paper has two main parts. The first, based on a comprehensive analysis of data over 1980–2007, examines how a country’s choice of exchange rate regime affects both its own macroeconomic performance (inflation, growth, crises) and its interaction with the rest of the system (external adjustment, trade integration, capital flows). The second looks at potential sources of stress to the system, including the possibility that countries seek to accumulate additional reserves in response to the crisis, the persistence of large global imbalances, and the risk of a sudden change (or “tipping point”) in the reserve currency status of the U.S. dollar.
Key findings may be summarized briefly. As regards individual countries’ choice of regime, the message is more nuanced than in earlier studies, particularly with regard to the recommendation that EMEs should move to one of the two extremes of the regime choice spectrum (essentially the tradeoffs are more complex, summarized as follows):
Pegged exchange rate regimes provide a useful nominal anchor for both developing and emerging market countries, delivering lower inflation than other regimes (including those with explicit inflation-targeting frameworks) without compromising growth performance. The main exception to this inflation dividend is cases where the country has a large current account surplus and is unable to permanently sterilize the resulting reserve inflows.
Intermediate exchange rate regimes, by combining the benefits of still relatively low exchange rate volatility with a competitive level of the real exchange rate (reflecting the “management” of exchange rates to avoid overvaluation), are associated with fastest output growth, particularly in EMEs. Pegged and intermediate regimes are associated with deeper trade integration, which is also growth-enhancing.
Floating exchange rate regimes, however, are associated with lower susceptibility to financial crises and faster and smoother external adjustment than pegged or intermediate regimes. Less flexible regimes are associated with larger external imbalances (surplus or deficit) and, in the case of deficits, more abrupt adjustment (whereas surpluses tend to be highly persistent under these regimes).
These findings underscore that the key trade-off is not between inflation and growth (nonfloating regimes are generally associated with lower inflation and higher growth), but rather between performance along these dimensions on the one hand, and the greater risk of crisis and delayed external adjustment, on the other. Against that backdrop, a country should choose the regime best suited to address its particular economic challenges, factoring into its decision in systemic cases the implications of that choice for overall systemic stability.
Turning to systemic issues, three related potential sources of instability can be identified.
First, it is probable that some countries will emerge from the current crisis determined to bolster self-insurance by building up even larger war chests of reserves against the possibility of future crises. In the extreme, this could lead to a scramble for reserves and pressures for competitive depreciations. Avoiding such an outcome may require providing countries with an adequate substitute to hoarding reserves—a larger IMF, greater access to IMF resources—or a synthetic reserve asset that does not require corresponding balance of payments surpluses and deficits (e.g., Special Drawing Right allocations).
Second, the empirical finding that imbalances (especially surpluses) tend to be more persistent under less flexible exchange rate regimes, coupled with the finding that the low inflation benefits of pegs are lost when there are large current account surpluses, suggests that greater exchange rate flexibility in key surplus countries would tend to reduce systemic risks without undercutting domestic economic performance; indeed, such performance could even be enhanced, as the empirics in the paper point to the growth benefits of intermediate regimes—a category that spans managed floats and allows for considerable flexibility. Greater exchange rate flexibility in key surplus countries, together with the policies envisaged by the Multilateral Consultation for other participants, could thus reduce systemic risks associated with the global imbalances while supporting sound economic performance at the national level.
Third, while the crisis initially saw “flight to quality” flows boosting the U.S. dollar, continued U.S. deficits over the long term could eventually undermine confidence in the dollar’s reserve currency status, with any stock switch in the composition of reserve currencies being highly disruptive to the global system. Although there are good reasons to believe that no sudden tipping point will occur, this belief is predicated on anchoring expectations by articulating a path for exit policies (fiscal, monetary, financial) that would credibly narrow future deficits, as well as on providing countries with viable alternatives to reserves accumulation to satisfy precautionary demand.
Promoting stability of the overall system of exchange rates is an individual and collective endeavor of all IMF members. For countries that are not systemically large, the choice of exchange rate regime should be tailored to their particular economic challenges, with the proviso that those opting for less flexible regimes should ensure strong economic fundamentals to minimize the risk of (potentially contagious) crises. For systemic countries (or those that in aggregate are systemically important), a further consideration in the choice of regime (and of economic policies more generally) would be to moderate global imbalances. Finally, the IMF, within its mandate, should provide sufficient mechanisms to meet the evident underlying demand for precautionary reserves by its members.
IMF Articles of Agreement, Article IV, Section 1. For a legal interpretation, see IMF (2006).