Each member country of the International Monetary Fund undertakes to collaborate with the IMF and other members to ensure orderly exchange arrangements and promote a stable system of exchange rates. This goal is served by countries adopting exchange rate regimes that best help them address their particular macroeconomic challenges, with due regard to the stability of the overall international monetary system.
With respect to individual countries’ choice of exchange rate regime, the message of the present study is more nuanced than those of previous IMF reviews. In particular, whereas Mussa and others (2000) stressed the bipolar view of the exchange rate regime choice (either full flexibility or full commitment to a hard peg) and Rogoff and others (2004) argued even more strongly in favor of flexible arrangements for EMEs, this study finds some important benefits from pegged and intermediate regimes for both EMEs and developing countries. At the same time, there may be significant tradeoffs in adopting such regimes, both at the individual country level and, in some cases, from the viewpoint of systemic stability.
Much of the benefit of pegged regimes appears to derive from the enhanced commitment to a stable nominal anchor offered by an explicit (de jure) peg, which results in lower inflation. Among emerging market countries, inflation is lower in countries with pegged regimes relative both to other regimes and to inflation targeters. However, countries with a pegged exchange rate that are running large current account surpluses (perhaps owing to a peg at an undervalued rate) actually face higher inflation, as upward pressure on the real exchange rate is manifested via increases in the domestic price level. In addition, pegged regimes are associated with very significant constraints on policy activism (both fiscal and monetary), suggesting that the additional policy discipline required to sustain the peg comes at the cost of a reduced ability to offset shocks via other policy tools.
The analysis also suggests that intermediate regimes are associated with higher economic growth in emerging markets. The channels are, however, less obvious than in the case of inflation, reflecting broader uncertainties about what drives economic growth in this and other segments of the IMF’s membership. This being said, intermediate regimes appear less prone to bouts of overvaluation that tend to undercut growth under pegged regimes, while also achieving lower inflation and real volatility than floating regime cases.
As stressed in the IMF’s Articles of Agreement, a stable system of exchange rates should facilitate the exchange of goods, services, and capital. Pegged exchange rate regimes unambiguously reduce risk and uncertainty associated with cross-border transactions, and hence would tend to strongly underpin trade flows. Pegged exchange rates (a fortiori, currency unions) therefore appear particularly useful for countries seeking greater regional integration. Turning to capital flows, floating regimes appear to be associated with less fundamentals-driven financial flows than other regimes.
Set against the findings that less flexible regimes are associated with lower inflation and better growth performance is their generally greater susceptibility to financial crisis and reduced facility in unwinding external imbalances. Less flexible regimes are associated with a higher incidence of currency crises and, in developing and emerging market countries with open capital accounts, with greater likelihood of (home-grown) financial crises. Accordingly, countries that do choose to peg their exchange rates, including to reap the inflation benefits, need to ensure that their fundamentals are sufficiently strong to help offset the greater risk of crisis. Finally, the empirical analysis suggests that less flexible regimes tend to have larger and more persistent current account surpluses, as well as greater likelihood of an abrupt and more costly reversal of large deficits.
What are the implications of these findings for the IMF’s diverse membership? The principal conclusion—in contrast to the earlier studies—is that a thorough analysis of the cross-country data does not support any single “prescription.” There are clear trade-offs—relevant from an individual country’s viewpoint and from the standpoint of spillovers to other countries and systemic stability—among the goals of achieving nominal stability and sustained economic growth, reducing crisis risk, easing external adjustment, encouraging integration, and securing broad systemic stability.
At present, the most salient risks to the stability of the system as a whole include a possible postcrisis scramble by countries to accumulate precautionary reserves (which might imply a further widening of global imbalances as well as risks of trade wars) and, over the longer term, potential threats to the reserve currency status of the U.S. dollar, which could be disruptive if they come about as an abrupt tipping point rather than as a gradual diversification into other reserve currencies. The tools available to the countries to manage such risks include provision of alternatives to reserves accumulation to meet the demand for country insurance (a larger IMF, greater access, a greater role for synthetic reserve assets such as the SDR that provide insurance without implying the need to run external surpluses/deficits), policies to underpin confidence in the currencies that anchor the system (including credible exit strategies by countries at the center of the crisis), and policies to reduce risks associated with the global imbalances themselves (including greater exchange rate flexibility in systemic nonfloating countries). Individually and in the aggregate, the policies needed to secure a stable evolution of the system would appear to be manageable. But equally, costs of inaction would be substantial, underscoring the IMF’s key role—consistent with its mandate to oversee the stability of the international system—in galvanizing broad support to meet the challenges that lie ahead.