In choosing an exchange rate regime, countries must consider the confidence and stability provided by a pegged exchange rate, versus the control over monetary policy offered by a floating rate. Vulnerability to external shocks, such as a sudden shift in commodity prices, influences the choice. A floating currency allows a country to adjust to external shocks through the exchange rate. A pegged exchange rate provides a nominal anchor, thereby requiring domestic wages and prices to adjust in the face of external shocks.
Over the past decade, global exchange rate arrangements have undergone momentous changes—some voluntary and orderly, others in response to exchange market pressures. In a recent IMF Working Paper, Rupa Duttagupta of the IMF’s Monetary and Financial Systems Department and Inci Otker-Robe of the IMF’s Policy Development and Review Department analyze the determinants of exits from pegged regimes. They spoke with Christine Ebrahim-zadeh of the IMF Survey about their findings.
IMF Survey: Why did you focus on exits from pegged exchange rate regimes?
Otker-Robe: For quite some time, more rigid forms of pegs were praised for their contribution to countries’ stabilization efforts. More flexible pegged regimes, such as horizontal or crawling bands, were viewed as a way to address the fundamental trade-off between anchoring inflation expectations and providing some flexibility in coping with external shocks and safeguarding competitiveness.
Following some major currency crises over the past decade, pegged regimes fell out of favor—with a growing perception that pegs may not be sustainable, especially in the context of high capital mobility. This controversy motivated us to look at the factors that contribute to the manner of exits from pegged exchange rates.
Duttagupta: We also felt that analyzing the factors that led countries to abandon pegs and examining the nature of the exits would yield a better understanding of the conditions under which countries could make orderly exits and help minimize the risk of crisis-driven exits.
Otker-Robe: The downside of focusing only on pegged regimes, of course, is that we miss some interesting cases that involve exits from floating regimes to soft or hard pegs. Ecuador’s switch from a float to full dollarization after the financial crisis of 1999 comes to mind, for example, as does Malaysia’s move to a fixed peg in 1998. Looking at the determinants of such exits could be an interesting extension to this paper.
IMF Survey: What types of exits did you focus on?
Duttagupta: We distinguish among five kinds of exits from a given pegged spell—that is, the period during which a given peg level is in effect:
Exits caused by exchange market pressure—these involve either depreciations or shifts to other regimes.
Exits involving orderly adjustments within the same regime—for example, step devaluations or revaluations within fixed or crawling pegs or bands.
Orderly shifts to more flexible regimes—for example, shifts from pegged to floating regimes, hard to soft pegs, fixed or crawling pegs to bands, and also widening of bands within band regimes.
Orderly shifts to less flexible regimes—such as shifts from soft to hard pegs and from band regimes to fixed or crawling pegs.
Orderly shifts to other regimes that cannot be unambiguously ranked vis-à-vis the exited regime in terms of flexibility of the exchange rate policy—shifts between alternative types of fixed pegs, for example.
IMF Survey: And what are the determinants of these exits?
Duttagupta: We found, as expected, that the determinants are related to the nature of the exits. Crisis-driven exits, in particular, tend to follow a deterioration of economic health, such as a decline in export growth and official international reserves and an appreciation of the real exchange rate relative to its trend. These exits are also more typical of emerging market economies—reflecting, in part, their greater susceptibility to volatile capital flows, which affect the sustainability of pegs.
As for orderly exits, shifts to more flexible regimes are associated with emerging market economies, greater trade openness, and a measure of monetary relaxation proxied by higher government borrowing from banks. Greater trade openness could increase exposure to terms of trade shocks, just as emerging market economies could be more exposed to volatile cross-border flows. In either case, more flexible regimes might absorb financial or trade shocks better.
Shifts to less flexible regimes are associated with a decline in banks’ foreign liabilities relative to their foreign assets and an increase in official reserves. The former could be indicative of a decline in vulnerability to exchange rate risk, thus supporting a shift to a less flexible regime. In the same spirit, higher official reserves would support the maintenance of a rigid exchange rate anchor.
IMF Survey: Does the nature of an exit have anything to do with how long an exchange rate regime has been in place?
Otker-Robe: Our empirical analyses suggest that it does. We found that exits to less flexible regimes—compared with other kinds of exits—were preceded by pegged spells of relatively long duration. The probability of an exit to a less flexible regime rises with the duration of the pegged spell, while the probability of adjustments within the same regime declines with duration. Intuitively, you might think that long duration of a peg indicates that the exchange rate anchor is serving the economy well, thereby supporting the shift to a less flexible regime. However, we found that crisis-driven exits, too, are preceded by a relatively long duration of a given peg, implying that any existing inconsistencies between the peg and other economic policies could be exacerbated by longer peg duration.
We should make a note of one point, though. Our analysis focuses on the duration of a given level of peg—what we call “pegged spells”—rather than the duration of the regime associated with this peg. Duration of a given regime could be longer than within a pegged spell. For instance, a spell within a fixed-peg regime ends when there is a devaluation. By contrast, the fixed-peg regime would end only if there were a shift to another exchange rate regime. Exploring the duration of various exchange rate regimes and the nature of exits from them is the subject of an ongoing project.
IMF Survey: What broad economic characteristics determine how flexible a country’s exchange rate should be?
Duttagupta: Our paper does not explicitly address this question, but some general observations can be drawn. For example, our results indicate that, with increases in cross-border trade and financial flows, countries—particularly emerging market economies—have shifted to relatively more flexible regimes, presumably to allow the exchange rate to accommodate external shocks. Alternatively, with a long period in a pegged spell, accumulation of “sufficient” foreign reserves, and low foreign exchange exposures of banks, countries have tended to shift to more rigid pegs, perhaps because these factors bolster the suitability of a relatively rigid regime for the country. These results do not imply, however, that countries with large foreign reserves and low exchange rate risk exposure cannot or should not have flexible regimes.
Otker-Robe: More generally, theory suggests that high capital mobility, low labor market flexibility, a lack of fiscal flexibility or sustainability, less economic diversification, and frequency of real shocks are among the most important features that call for more flexible exchange rates. Sound financial policies are, of course, necessary for any exchange rate regime. However, the degree of exchange rate flexibility is influenced by many other factors that are difficult to pin down, theoretically or empirically. For example, a country that seems to be a good candidate for a flexible regime may choose to peg if rapid disinflation is needed. Similarly, a good candidate for a pegged regime may choose to float if its most pressing problem is external adjustment and it lacks sufficient reserves to credibly defend the peg. Some operational factors also come into play: the lack of developed foreign exchange and money markets, a high degree of dollarization, and low implementation capacity make it difficult to adopt a flexible exchange rate regime. Some studies have also found that the actual regime choice may be the result of historical or political factors. That is probably why we sometimes observe two economies with similar characteristics opting for different exchange rate regimes.
IMF Survey: What should policymakers take from your results?
Otker-Robe: Our two main conclusions are that crisis episodes associated with pegged spells are generally preceded by a deterioration of economic indicators and that orderly exits to less flexible regimes are associated with longer durations with a given peg and improved indicators of economic and financial health. These findings suggest that strong economic and financial conditions are necessary for the sustainability of pegs, in particular, relatively rigid regimes. They also suggest that delaying exit from a peg—when there are indications of inconsistencies between the exchange rate and other policies—could result in a disorderly exit. We also found that having an IMF program plays no role in either disorderly or orderly exits.
Duttagupta: These results can also help policymakers understand the conditions under which orderly shifts from pegs could be accomplished and how crisis-driven exits could be avoided.
Copies of IMF Working Paper No. 03/147, “Exits from Pegged Regimes: An Empirical Analysis,” by Rupa Duttagupta and Inci Otker-Robe, are available for $15.00 each from IMF Publication Services. Please see page 9 for ordering details. The full text is also available on the IMF’s website (http://www.imf.org).