Experience with dollarization is so limited, and empirical data so scant, that any definitive assessment of it at this stage is foolhardy, according to Guillermo Calvo of the University of Maryland. But, addressing an IMF Institute seminar on May 11, he noted that current circumstances do provide the ingredients for an “interesting debate.” He counseled taking a fresh look at the assumptions shaping this debate, stressing that his presentation would focus on “how to think about these issues” rather than on conclusive recommendations. He did suggest, however, that analysts and policymakers take a hard look at the real options for exchange rate regimes in emerging economies. What they may find, he said, is that floating regimes may be more illusion than fact and that fixed rates, particularly full dollarization, might emerge as a sensible choice for some countries, especially in Latin America.
A number of questionable assumptions, Calvo warned, are muddying the ongoing debate over dollarization. In the aftermath of major financial crises in the previous decade, fixed exchange rates have fallen out of favor, and dollarization is frequently viewed as a drastic measure, requiring, among other things, the surrender of the central bank’s ability to function as a lender of last resort. But dollarization may not be the sharp departure from existing practices that its critics assume. Partial dollarization, for example, already characterizes a number of Latin American economies, he explained. Analysis of this issue commonly focuses on deposit (asset) dollarization, but debt (liability) dollarization is equally important. Individual borrowers with foreign exchange—denominated debts not matched by foreign exchange—denominated assets can be forced into bankruptcy by any depreciation of the exchange rate. The presence of such currency mismatches may argue for full dollarization.
Capital flows and “sudden stops”
If the merits of dollarization are to be weighed frankly, Calvo noted, it is useful to broaden the discussion and examine the realities in which exchange rate regimes operate in emerging economies. According to Calvo, a structural shift occurred in financial globalization around 1989. Official capital flows shrank, as volatile private markets assumed an increasingly important role. In Latin America, Brady bonds, hailed as the solution to the region’s debt problem, also had the unforeseen effect of spurring the growth of a bond market, which in turn led to large portfolio inflows. Portfolio funds appeared to peak in the late 1990s. After a severe contraction following the Russian crisis, they seemed unlikely to recover quickly, he added.
Current capital markets are best characterized as “moody,” Calvo said. They are heavily dependent on access to good information, but few participants have good information about emerging markets, so everyone else must follow the leaders. These qualities of the market leave it vulnerable to the sharp mood swings that have characterized the 1990s. The sudden stops in flows, which wreaked havoc in emerging markets over the previous decade, are not unprecedented, but did require “enormous adjustments,” according to Calvo. These swings, and the corresponding adjustments, are also dishearteningly at odds, he confessed, with the cushioning effect neoclassical economics predicted would result from the development of capital markets in such economies.
The volatility of the past decade has also called into question the ability of central banks in emerging market economies to handle crises of this magnitude. Calvo noted that these central banks lack the resources to carry out the crisis management tasks expected of them. And external assistance has been spotty at best, he said. The Group of Seven’s efforts were effective in Mexico and Korea, but proved slow and marginal elsewhere. This hesitance to become involved should not be surprising, Calvo added, since the central banks of the Group of Seven countries have no mandate to stabilize world markets.
In discussing exchange rate options in emerging market countries, full weight needs to be given, Calvo observed, to the environment in which that policy will be implemented. Capital in emerging markets has been moving with an intensity not seen since the late nineteenth and early twentieth centuries. This suggests that a system of fixed exchange rates—like the gold standard system of that era—might again be appropriate.
Fear of floating
Turning to the broad issue of whether a fixed or floating exchange rate regime would be more appropriate for emerging market countries, Calvo challenged the current fashion that favors floating. The Group of Seven had “demonized” fixed rates, he said, but the reality is that any exchange rate that moves at all is now being labeled a floating exchange rate. In truth, these “floating” regimes are considerably removed from what is classically defined as a floating exchange rate.
Comparing monthly data for a selected group of emerging and advanced economies, he noted that the currencies of emerging market economies were decidedly less likely to fluctuate than those of the major industrial countries. The emerging market countries were also considerably more likely to experience interest rate changes. This evidence suggested, according to Calvo, that policymakers in the so-called floating rate regimes of emerging markets may not intervene directly in the exchange market but may demonstrate a marked willingness to use interest rate policy to stabilize the exchange rate.
Calvo also drew attention to the high international reserves that have characterized the floating exchange rate regimes of many emerging market countries. In the classical view, a floating exchange rate arrangement should obviate the need for countries to carry high reserves. Possibly because of the incomplete nature of these markets and the inevitable credibility issues, emerging markets perceived a need to “float with a life jacket”—that is, to carry high reserves and pay the attendant costs.
More controversially, Calvo suggested that inflation targeting, which was increasingly finding favor in some emerging market economies, could actually be viewed as a form of fixing. Instead of fixing to the price of one unit of foreign exchange or tradable goods, he said, a country that pursues inflation targeting simply fixes to the price level. He added that inflation targeting is not without its pitfalls. Sound banking and financial systems are essential preconditions for inflation targeting; countries with structural problems would perhaps be better off with dollarization, Calvo said. He also cautioned that inflation has been a sleeping monster in recent years. What happens if that monster reawakens? Resurgent inflation, he was convinced, would quickly put pressure on inflation targeting in emerging market economies and force its eventual abandonment.
Calvo addressed the lender of last resort function of central banks in emerging markets. It is the absence of this function that critics have seized upon to question the wisdom of dollarization. But Calvo argued that the lender of last resort capabilities in emerging market countries are largely a “mirage.” Without extraordinary levels of reserves at their disposal, emerging markets often find they have extremely limited (and often undesirable) options in a crisis. In this situation, bailing out a banking system requires extensive lines of external credit, but these typically dry up in an emergency. The alternative—printing money—risks fueling inflation.
Emerging market countries that opt for dollarization can partially substitute for the lender of last resort function by setting up external lines of credit. Argentina has come up with an interesting proposal for full dollarization, Calvo added. Under the proposal, the country was seeking to receive from the United States the present discounted value of the seigniorage associated with adoption of the U.S. currency. Calvo did not believe this was likely to happen, however.
To fix or float…
Perhaps the key point to remember in the debate over whether a fixed or a floating rate is more appropriate for an emerging market economy, Calvo explained, is that these economies are still “emerging.” They are setting policy, he said, in a world in which their own financial markets remain underdeveloped, structural rigidities abound, and corporate sectors have very limited opportunities to hedge. In these emerging market economies, stock markets are relatively recent phenomena and bank lending continues to be the dominant form of financing. Exchange rate movements are costly in this environment, he stressed. Indeed, he argued, if the realities of the emerging market economies are fully factored into the decision on exchange rate regimes, the fixed option might look very attractive.