Exchange-Rate-Based Stabilization: A Critical Look at the Stylized Facts
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Mr. A. J Hamann
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https://orcid.org/0000-0002-6363-0398
Publication Date:
08 Nov 2001
eISBN:
9781451974614
Language:
English
Keywords:
SP; ERBS program; episodes 9; inflation country; stabilization episode; case of ERBS; Exchange rates; Inflation; Current account balance; Exchange rate anchor; Real exchange rates
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Do exchange-rate-based stabilizations generate distinctive economic dynamics? To address this question, this paper identifies stabilization episodes using criteria that differ from those in previous empirical studies of exchange-rate-based stabilizations. We find that, while some differences can be detected between exchange-rate- based stabilizations and stabilizations where the exchange rate is not the anchor, the behavior of important variables does not appear to differ—especially output growth, which is good in both cases. There is also no evidence that fiscal discipline is enhanced by adopting an exchange rate anchor, or that there are any systematic differences in the success records of stabilizations that use the exchange rate as a nominal anchor and those that do not.

Abstract

Do exchange-rate-based stabilizations generate distinctive economic dynamics? To address this question, this paper identifies stabilization episodes using criteria that differ from those in previous empirical studies of exchange-rate-based stabilizations. We find that, while some differences can be detected between exchange-rate- based stabilizations and stabilizations where the exchange rate is not the anchor, the behavior of important variables does not appear to differ—especially output growth, which is good in both cases. There is also no evidence that fiscal discipline is enhanced by adopting an exchange rate anchor, or that there are any systematic differences in the success records of stabilizations that use the exchange rate as a nominal anchor and those that do not.

In recent years, several articles have identified a set of empirical regularities that arise during exchange-rate-based stabilization (ERBS) in high inflation countries. These empirical regularities are presumably not observed when the inflation stabilization strategy does not rely on the use of the exchange rate and are, thus, commonly referred to as the ERBS “syndrome.” 1 The main features of the syndrome include a boom-bust cycle (as opposed to the initial recessionary effects of money-based stabilizations); a consumption (and sometimes also an investment) boom; a pronounced real exchange rate appreciation; and worsening trade and current account balances. In addition, the literature points out that there is a particularly high incidence of failure among ERBS in high inflation countries.

It is quite surprising that, although the identification of an ERBS syndrome was based on a relatively small sample of countries from Latin America and Israel and its relevance for other countries has not been studied, it has nonetheless inspired a growing theoretical literature. 2 There are also potentially serious methodological problems with the way in which the comparison of ERBS with other stabilizations has been usually carried out. Most importantly, there are inconsistencies in the timing of ERBS and the typical control group of money-based stabilizations (MBS), as the former presumably start when the exchange rate is actually pegged whereas the latter are assumed to begin when they are announced. In addition, there is no obvious reason why the control group against which the ERBS have been compared should be confined to MBS; instead it should include all non-ERBS, that is, a broader class of programs that includes those where no strict monetary or exchange rate rule was pursued.3

This paper looks at the stylized facts of ERBS and other stabilization plans where the exchange rate was not the anchor (OS), trying to correct some of the problems mentioned above. To this end, the paper follows earlier work by Ball (1994) and Easterly (1996) and constructs a set of inflation stabilization episodes on the basis of a simple numerical rule. The timing of all inflation stabilizations, ERBS and otherwise, is, thus, based on a common criterion. In addition to the elements of the ERBS syndrome, the paper looks at the issue of financial discipline, which, according to a widely held view, is enhanced by the use of the exchange rate as an anchor. It must be stressed, however, that the paper is mainly descriptive: it identifies patterns in the data and examines their robustness, rather than carrying out formal tests of competing hypotheses. In this sense, the paper should be viewed as a first attempt at establishing stylized facts on the basis of a rule-based selection of inflation stabilization episodes, leaving formal testing of other important issues for further research. 4

The results are not totally supportive of the ERBS syndrome described in the literature. While differences in the behavior of some macroeconomic variables between ERBS and OS were detected, there is no evidence of a “recession now vs. recession later” trade-off between ERBS and OS; in fact, growth performance during stabilization is good in both groups, as had been found by Easterly (1996). There is also no evidence that fiscal discipline is enhanced by the adoption of an exchange rate anchor, or that there are any systematic differences in the records of success of ERBS and OS.

I. Identifying Stabilization Episodes

The selection of the inflation stabilization episodes used in this study is based on the application of some rules to a data set of annual inflation rates for the period 1960-1997 for a group of 143 countries. 5 The alternative to a rules-based method for selecting episodes would be a comprehensive review of the history of those countries, aimed at identifying periods in which governments put in place anti-inflation economic programs. This alternative route would necessarily entail some controversial judgements regarding, for instance, whether to exclude programs that could not be considered serious attempts at disinflation, or programs that were abandoned soon after they were implemented. Furthermore, in most cases, identifying the precise timing of stabilization episodes could be equally arbitrary. It is not always the case that inflation stabilization programs have a clearly identifiable start date, with the exceptions being perhaps those in which the exchange rate played a central role and its future path was announced along with other measures. 6 It is often the case, moreover, that inflation is successfully brought down after more than one attempt and, even in those cases, it is not entirely clear when a given stabilization plan ended and the next one began.

Another alternative would be to rely on existing work documenting stabilization programs in high inflation countries. But those studies are not likely to provide a comprehensive account of stabilization episodes. One of the purposes of the present study is to examine a range of inflation stabilization episodes that goes beyond the set that has been well documented in the literature. Furthermore, doubts about the precise timing of the stabilization programs and consistency across countries of the methodology for selecting relevant episodes are not likely to be resolved by relying on a survey of existing studies of stabilization experiences. However, it must be acknowledged that, whereas specifying a rule for selecting inflation stabilization episodes simplifies the task of identifying episodes enormously and does not discriminate against programs that have not been documented, it does not remove subjectivity completely from the analysis. Rules will be unavoidably arbitrary but the patterns detected under one set of rules can be checked for robustness with respect to small changes in the eligibility criteria.

Ball (1994) and Easterly (1996) have used rules for the identification of inflation stabilization episodes. Building upon earlier work by Bruno and Easterly (1995), Easterly (1996) defines a stabilization episode as a movement from an “inflation crisis” to a “non-crisis” period where the former is defined as a period of at least two consecutive years of inflation above 40 percent and the latter as a period of at least two consecutive years with inflation below 40 percent. The two-year minimum is used to eliminate spikes in inflation due purely to one-time price shocks such as changes in key import prices, devaluations, or price liberalizations. The 40 percent threshold level is found by Bruno and Easterly (1995) to be useful in discriminating between periods of very high inflation and moderate to low inflation. To establish the timing of stabilizations, Easterly defines the peak year during the crisis period as “year 0,” or the stabilization year, and the year after the peak as the first post-stabilization year.

Easterly found 28 stabilization episodes, shown under Criterion (1) in Table 1, and his rule could be considered a relatively stringent criterion for the selection of stabilization episodes. Notably, the list excludes a number of well-documented, albeit mostly failed, stabilization attempts, including Argentina and Chile′s tablitas of the late 1970s, and the heterodox programs of Argentina, Brazil, and Peru in the mid-1980s. The sample also excludes several programs in Africa. In a deliberate attempt to produce a larger sample, three alternative rules were used here to identify stabilization episodes, all of them based on the requirement that, prior to stabilization, inflation remained at or above 40 percent for at least two years:

  • Criterion (2): stabilization occurs when inflation is brought down below 40 percent and remains below 40 percent for at least another year.

  • Criterion (3): stabilization occurs when the inflation rate is lowered by at least one-quarter the first year and remains below the pre-stabilization level for at least another year.

  • Criterion (4): stabilization occurs when the inflation rate is lowered by at least one-half the first year and remains below the pre-stabilization level for at least another year. The results of applying the three rules to the data are shown under Criteria (2)-(4) in Table 1.7 Criterion (2) produces 34 stabilization episodes, of which 22 coincide with those in Easterly′s sample.8 The timing of stabilization, however, tends to be delayed by a year in most cases, reflecting in part the fact that Easterly′s selection was based on end-of-period inflation whereas in this paper average inflation was used.9,10 The fact that this rule does not produce a very large number of episodes shows the discriminating power of the 40 percent threshold, since no minimum reduction in inflation is required. A potential shortcoming of this criterion, however, is that it could pick up cases in which inflation may have been lowered from slightly over 40 percent to slightly less than 40 percent, which would not represent economically meaningful stabilization episodes. In fact, only two marginal cases were picked up and were dropped from the sample: Israel 1976 and Guinea 1982.

Table 1.

Stabilization Episodes

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Sources: Easterly (1996), IMF International Financial Statistics (IFS), and national sources.

Date of nearest IMF arrangement, prior to earliest stabilization date among criteria (l)-(4).

First year after peak inflation in a transition from a high inflation to a low inflation period. The former is defined as at least two years of inflation above 40 percent and the latter as at least two years of inflation below 40 percent.

First of at least two years of inflation below 40 percent, following at least two years of inflation above 40 percent.

Year of at least 25 percent reduction in the inflation rate from a level of at least 40 percent, preceded by at least another year of inflation above 40 percent. Inflation in the second year of stabilization must remain below its level in the last pre-stabilization year.

Year of at least 50 percent reduction in the inflation rate from a level of at least 40 percent, preceded by at least another year of inflation above 40 percent. Inflation in the second year of stabilization must remain below its level in the last pre-stabilization year.

Unlike Criterion (2), Criterion (3) does not impose a uniform ceiling on post-stabilization inflation but requires a reduction of at least one-quarter in inflation in the first year of stabilization. This proved to be a significantly less restrictive criterion, as it produced 51 stabilization episodes, including all 28 found by Easterly (although 17 of them are dated a year later). This criterion also picks up the well-known episodes not captured by Easterly′s rule, mentioned earlier.11 Criterion (4), which requires halving inflation as a minimum, produced 36 episodes, including 22 of the 28 identified by Easterly. It was decided, therefore, to carry out a comparative study of the stylized facts that would arise from the two samples produced by the most stringent and loosest criteria: Easterly′s and Criterion (3).

Since the episodes contained in the two samples to be used in this study were selected exclusively on the basis of inflation performance, some additional information that stabilization programs were actually put in place in those cases is needed in order to rule out the possibility that the selected episodes represent positive supply shocks. One way to deal with this issue is to check for the existence of IMF-supported programs during a period of, say, up to two years prior to the stabilization date identified in Table 1. Of the 55 episodes listed in Table 1, 41 were preceded by, or coincided with, an IMF-supported program. Moreover, 38 of the 51 episodes identified by Criterion (3) were preceded by or coincided with an IMF-supported program, and there is further evidence that in most of the remaining 13 cases, stabilization programs were put in place: Argentina 1980 actually represents its tablita experiment, which ran from December 1978 to February 1981; Brazil 1999 is President Collor′s stabilization plan of 1990-91; Indonesia′s “stabilization and rehabilitation” program, started in 1966, is documented by Azis (1994); the Israeli stabilization plan has been analyzed extensively—Bruno and Piterman (1988) is the first of several studies dealing with the Israeli stabilization; Iceland′s two stabilization plans are reviewed by Andersen and Guomundsson (1998); and Ghana′s strategy to mop up excess liquidity in 1978 is documented by Sowa (1993). Other episodes are not well documented in the literature but clearly constitute bona-fide stabilization programs: Lebanon′s 1993 stabilization is part of the economic reconstruction plan started in 1991 following the Taif peace treaty, and Ecuador 1994 reflects the efforts of that country′s authorities to bring down inflation through the active use of the exchange rate as a tool to anchor expectations about inflation. Thus, of the 51 episodes identified associated with Criterion (3) there are only 4 for which there is no independent evidence of the adoption of a stabilization plan: Guinea Bissau 1993, Lebanon 1988, Sierra Leone 1992, and the Syrian Arab Republic 1988.

There are other problems associated with the identification of stabilization episodes based exclusively on the actual behavior of inflation. First, since the selected stabilization episodes are those for which a given reduction in inflation is actually observed, it follows that the resulting sample is composed mainly of programs that enjoyed some degree of success. Short-lived programs that did not manage to make a significant dent in average annual inflation would not have been picked up. Second, the rules may be picking up the delayed effects of programs that pursued more than one objective at a time or, more likely, programs that pursued a sequence of events, such as restoration of external balance first, and only subsequently a reduction in inflation. Thus, either by pushing forward the timing of stabilization, or by focusing only on relatively successful episodes, it is likely that the sample of episodes identified here may be biased in the sense of being associated with a more positive economic outlook around stabilization time (that is, higher growth, better external accounts, etc.). While no systematic attempt to correct these potential biases is made in this paper, the issue is informally taken into account when interpreting the results.

In the following sections, Easterly′s sample, which will be denoted as Sample 1, and the sample arising from using Criterion (3), which will be referred to as Sample 2, will be used. It is hoped that a comparison of the results generated by each of these samples will shed some light about whether the identified stylized facts are robust to changes in the precise statistical definition of a stabilization episode. In particular, the fact that 17 of the 28 episodes shared by both samples are dated differently will provide a robustness check against the rule followed for timing stabilization episodes.

II. Nominal Anchors and Stylized Facts

Sample 1 was split into ERBS and OS in Easterly (1996). ERBS were identified as cases in which the exchange rate was fixed as part of the program and the country had current account convertibility.12 Of the 28 programs in Easterly′s sample, 9 were found to be ERBS. For Sample 2, the identification of ERBS was based on a two-stage procedure. First, information was obtained from the empirical literature on ERBS, as well as from IMF staff reports in the cases in which IMF-supported programs were in place at the time of stabilization. This first step led to the identification of 13 ERBS. For each of the remaining programs, the joint condition of a fixed exchange rate and current account convertibility was checked; this check did not reveal any additional ERBS. Table 2 shows the breakdown of Samples 1 and 2 into ERBS and OS. Since the stabilization dates in Samples 1 and 2 were obtained using a mechanical rule, the last column of Table 2 provides the dates in which exchange rates were actually pegged for the ERBS. The rules-determined and historical dates coincide in only 3 of the 13 ERBS in Sample 2. The historical date precedes the rules-determined date by one year in seven cases, and by two years in the remaining three cases.

The following subsections study the behavior of several macroeconomic variables during a seven-year window—from t-3 to t + 3, where t is the stabilization year.13 As a rule, the sample median, and a 95 percent confidence interval around it, are shown for each variable. Median was selected over the mean because sample means are in most cases seriously affected by a few extreme values; as a result, standard deviations and, thus, confidence intervals around the means tend to be extremely wide, rendering comparisons of means largely meaningless.

Table 2.

Stabilization Episodes: Anchors

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Sources: Easterly (1996), IFS, and national sources.

Year in which exchange rates were actually pegged, if peg occurred within the first six months of the year; the following year if peg occurred during the last six months of the year.

Financial Discipline

The key argument in favor of selecting an exchange rate anchor during disinflation relates to its ability to strengthen domestic financial discipline. The argument is that a credible commitment to a highly visible variable such as the exchange rate (as opposed to an inflation or money target) will be a relatively more effective way to eliminate an “inflation bias” in wage and financial contracts, and would provide a better incentive to produce the fiscal adjustment needed for the sustainability of low inflation and the viability of the peg itself.14 The theoretical merits of this argument aside, the empirical evidence on the ability of pegged exchange rates to strengthen financial discipline is mixed. After controlling for several factors, Edwards (1993) finds that countries that pegged their exchange rates at the beginning of the 1980s were financially more responsible than those with a more flexible exchange rate regime. However, in various studies Tornell and Velasco (1995a, 1995b, 1998) find no evidence in support of the view that the adoption of an exchange rate anchor imposes stronger fiscal discipline. Tornell and Velasco (1995b) show that during the 1980s, fiscal discipline was stronger among sub-Saharan countries with flexible exchange rate regimes than among those with fixed exchange rates (the franc zone countries); while Tornell and Velasco (1998) and (1995a) find that fiscal adjustment was stronger, and occurred more often, in money-based stabilizations (MBS) than in ERBS in Latin America.

The issue of financial discipline is discussed here in terms of the behavior of inflation pre- and post-stabilization and the evolution of fiscal and monetary variables. A comparison of the actual reduction in inflation between ERBS and OS is, in principle, not a valid way of judging the relative merits of these strategies in reducing inflation (especially when no control is made for the paths targeted for the exchange rate and money). Nonetheless, some (weak) results in favor of the financial discipline effect of exchange rate anchors emerge from Figures 1 and 2. According to both samples, inflation in the pre-stabilization years is higher in ERBS than in OS (at least 20 percentage points in the level of inflation), and yet post-stabilization inflation is lower in ERBS, although the difference is relatively small.15 And three years after stabilization, inflation is lower in ERBS than in OS in both samples. As before, however, differences in inflation performance between ERBS and OS are not statistically significant. Differences across regimes in the behavior of money growth rates are less clear; in particular, there is almost no difference in the average of median rates of money growth in the post-stabilization years, suggesting that real money balances grow faster after stabilization in ERBS than in OS.

The bottom panels of Figures 1 and 2 provide no evidence consistent with the view that fiscal discipline is stronger in ERBS. Fiscal adjustment in year t is stronger in ERBS in Sample 1 (l¼ p.p. of GDP vs.¼ p.p. in OS) but weaker in Sample 2 (¾ p.p. of GDP vs. 1 ½ p.p. in OS).16 When the cumulative change in the fiscal balance from t -1 to t +1 is considered, however, adjustment under OS is stronger (1 ¾ p.p. of GDP vs. 1½ p.p. in ERBS in Sample 1; 1 p.p. of GDP vs. - ¾ p.p. in ERBS in Sample 2). Fiscal balances deteriorate in the second or third post-stabilization years in all cases, but in no case do fiscal balances in year t+3 fall below their level in year t -1. To the extent that the difference in fiscal balances between years t +3 and t -1 can be considered as an indicator of the “durability” of the initial fiscal adjustment, better results are obtained in OS.

Figure 1.
Figure 1.

Sample 1: Inflation, Monetary and Fiscal Accounts

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.1The following transformation was used: x = Xl(1 + X).
Figure 2.
Figure 2.

Sample 2: Inflation, Monetary and Fiscal Accounts

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.1The following transformation was used: x = Xl(1 + X).

Important differences in pre-stabilization patterns of fiscal balances exist between ERBS and OS. Clearly, pre-stabilization fiscal deficits tend to be smaller in ERBS than in OS (about 3½ percent of GDP in ERBS vs. 5 percent of GDP in OS in both samples), suggesting that the prevailing fiscal situation may be a factor in the selection of an anchor during stabilization. On the other hand, adjustment in the runup to stabilization (from t -3 to t -1) is not necessarily greater under one type of program: the improvement in fiscal balance is larger in ERBS in Sample 1, but (slightly) larger in OS in Sample 2.

The ERBS Syndrome

As mentioned earlier, the main stylized facts of the ERBS syndrome identified in the literature are: a boom-bust cycle (as opposed to the initial recessionary effects of money-based stabilizations); a consumption (and sometimes also an investment) boom; a pronounced real exchange rate appreciation; and worsening trade and current account balances.

Figures 3 and 4 show the behavior of GDP and per-capita GDP growth around stabilization for both ERBS and OS in both samples. There appears to be no evidence from either sample of a “recession now vs. recession later” trade-off involved in the selection of nominal anchors. A slowdown in growth does occur in ERBS, as GDP growth rates decline by about 1 ½ p.p. two or three years after stabilization; this trend is clearer when per capita GDP growth rates are considered. But there is no evidence of a recession during (or following) stabilization in OS. Despite relatively wide confidence intervals in some cases, Figures 3 and 4 show that growth performance improves during inflation stabilization and its immediate aftermath both in ERBS and OS.

Figure 3.
Figure 3.

Sample 1: Growth of GDP and Per Capita GDP During Disinflation

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.
Figure 4.
Figure 4.

Sample 2: Growth of GDP and Per Capita GDP During Disinflation

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

The behavior of private consumption (as a percentage of GDP) does differ in ERBS and OS, as shown in Figure 5, but the key differences are statistically significant only in Sample 1. The top left panel of Figure 5 shows a sizeable (nearly 3 p.p. of GDP) and statistically significant increase in the private consumption-to- GDP ratio in the stabilization year, followed by an additionally (albeit smaller and not statistically significant) increase in year t + 1. The bottom left panel shows similar, but not statistically significant, results for Sample 2. Nothing remotely similar to this result can be found in the case of OS in either sample. Thus, there seems to be some statistical support to the “consumption boom” element of the ERBS syndrome described in the literature.

Figure 5.
Figure 5.

Private Consumption During Disinflation

(In percent of GDP)

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

Investment behavior in the post-stabilization years also tends to differ between OS and ERBS, as shown in Figure 6. In ERBS investment does not deviate considerably from its value in year t during the post-stabilization years, except for a 1 p.p. of GDP fall in year t + 3 in Sample 2. The picture is quite different in OS, where an increasingly positive deviation can be detected, especially in Sample 1 (investment in year t + 3 is 3 p.p. of GDP higher than in year t, although the difference is not statistically significant). In Sample 2, the differences between investment in years t + 2 and t + 3 and its value in year t are smaller, but statistically significant. In the pre-stabilization years, the clearest development is a decline of at least 1 p.p. of GDP in investment in year t - 1 in all cases; only in ERBS in Sample 2 does investment decline for two years prior to stabilization (the cumulative decline is 2½ p.p. of GDP). Thus, there is no evidence of an investment boom in ERBS, and instead, there is weak evidence suggesting that investment falls somewhat in the runup to stabilization in all cases. There appears to be somewhat stronger evidence suggesting that investment recovers more sluggishly or not at all in post-stabilization years following ERBS.

Figure 6.
Figure 6.

Investment During Disinflation

(In percent of GDP)

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

Moderate differences in the behavior of the current account balance in pre- and post-stabilization years seem to exist between ERBS and OS (Figure 7). In the case of ERBS, Samples 1 and 2 show changes in different directions in current account balances in the stabilization year and a deterioration following stabilization, although this trend is not statistically significant. In OS, on the other hand, there is no change in the median current account balance in the stabilization year and no clear pattern in post-stabilization years. Furthermore, the behavior of the current account balance provides another example of important differences in pre-stabilization dynamics, which may be indicative of endogeneity of anchor selection: the median deviations from values recorded in the stabilization year indicate an improvement in current account balances in ERBS (between years t -2 and t - 1 in Sample 1 and between years t -3 and t - 1 in Sample 2), but only minimal changes in OS.

Figure 7.
Figure 7.

The Current Account During Disinflation

(In percent of GDP)

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

Figure 8 shows some additional, but weak, evidence in support of one of the elements of the ERBS syndrome. The trends exhibited by the real exchange rate differ markedly between ERBS and OS: real exchange rates tend to appreciate before and after stabilization when the exchange rate is used as an anchor, but tend to depreciate before and after stabilization in OS. These changes are not statistically significant, however. Interestingly, there is a sizeable (about 10-20 percent) depreciation in year t -2 in all cases, which is consistent with the notion of restoration of external equilibrium prior to inflation stabilization discussed earlier. Quite clearly, in the ERBS the real appreciation is not only a post-stabilization phenomenon; in fact, for this to be the case ERBS would have had to be dated two years too late on average. Otherwise there is room to ponder whether policymakers may not have been managing the exchange rate with the purpose of lowering inflationary expectations for some time before they adopted a publicly-announced ERBS. There is also the possibility that, before the exchange rate was used explicitly as an anchor, tight monetary policy may have led to an appreciation before it caused a reduction in (average) inflation. On the other hand, for OS there is no clear evidence of real appreciation prior to inflation stabilization, except for a sizeable but not statistically significant appreciation in year t - 1 in Sample 1.

Figure 8.
Figure 8.

The Real Exchange Rate During Disinflation

(Value in year t= 100)

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

Using a sample similar to those used by the studies that first identified the ERBS syndrome, Gould (1996) found that the choice of nominal anchor is endogenously determined by the prevailing level of international reserves. Figure 9 provides some evidence of a possible systematic difference in the behavior of reserves prior to stabilization in ERBS and OS. Between years t-3 and t gross international reserves are generally higher in ERBS than in OS (3½ months of imports vs. 1 ¾ in Sample 1; 4½ months of imports vs. 2 months in OS in Sample 2). It must be stressed, however, that confidence intervals are quite wide in the case of ERBS and these differences in reserve levels are not statistically significant.

Figure 9.
Figure 9.

International Reserves During Disinflation

(In months of imports)

Citation: IMF Staff Papers 2001, 003; 10.5089/9781451974614.024.A004

Sources: IFS, national sources, and author′s estimates.

The difference in reserve holdings between ERBS and OS in post-stabilization years is minimal (3 vs. 2 ½ months in Sample 1; 3 ½ vs. 3 months in Sample 2). The similarity in levels in post-stabilization years reflects two opposite trends: in ERBS reserves fall in the stabilization year and, although they recover somewhat in the following years, they do not reach their pre-stabilization peak. In OS, on the other hand, there is a general upward trend in reserves around stabilization; this increase occurs in years t +1 and t + 2 in Sample 1 and between years t- 1 and t+1 in Sample 2. The different trends are unequivocal in year t, when inflation first comes down: reserves are falling under ERBS but going up under OS, although these changes are not statistically significant. A possible interpretation of the fact that reserves tend to increase in OS in post-stabilization years is that they really are not pure MBS. Rather, these programs may involve some form of intervention in the foreign exchange market in order to facilitate the remonetization of the economy.17

Success or Failure of ERBS

The ERBS literature often mentions a relatively high rate of failure among ERBS, but no formal claim has been made about a systematic tendency for one type of stabilization program to succeed or fail more frequently than the other. One could argue, however, that ERBS is an intrinsically riskier disinflation strategy because, by targeting the exchange rate, policymakers provide speculators with the opportunity of a one-sided bet, and thus, these programs can potentially fail even in cases where failure is not warranted by macroeconomic fundamentals. On the other hand, as has been discussed earlier, it has been argued that committing to a fixed exchange rate raises the game′s stakes and, therefore, that it is more likely to impose financial discipline, ultimately raising the probability of success. Looking at the rates of success of both ERBS and OS in the stabilization programs studied in Sample 2 can shed some light on the empirical relevance of these issues.

There is no obvious, clear-cut definition of success that can be used here, especially considering that, by following a rule that defines a stabilization episode as one that produced an actual decline in inflation that lasted for at least two years, one is already biasing the sample somewhat in the direction of success, however defined. Success would then have to be related to a program′s ability to keep inflation low for some time beyond the two-year horizon. In principle, it is tempting to require a relatively large number of years of stability to consider a program truly successful. However, there is a risk associated with using too large a number. If a program brings inflation down and keeps it down for, say, five years but then inflation spirals out of control beginning in year six, was the original program ultimately unsuccessful? Or could the new inflationary episode be the creation of a different economic team working in a different policy environment? Or could the economy have been hit by an extraordinarily adverse shock? It seems that the longer the number of years of low inflation required to consider a stabilization successful, the higher the risk that some truly successful program may be recorded as a failure.

Success was defined on the basis of inflation performance on the second and third post-stabilization years (t + 2 and t + 3). An obvious advantage of limiting the horizon to t + 3 is that a verdict (successful or not) could be reached for all 51 programs in Sample 2. Several rules were tried, of which two were selected, essentially because they did not produce extreme rates of success or failure:

  • Success—Criterion (1): during the second and third post-stabilization years, inflation remains at or below whatever level inflation reached during the stabilization year.

  • Success—Criterion (2): during the second and third post-stabilization years, inflation remains at or below three-quarters of the inflation rate prevailing the year before stabilization.19

The results are reported in Table 3. According to Criterion (1), which is more restrictive, 20 of the 51 programs were successful. Among ERBS, 5 out of the 13 programs were successful, which implies the same rate of success for ERBS (38 percent) as for OS (39 percent). If Criterion (2) is used, 34 out of the 51 programs can be considered successful. Interestingly, of the 13 ERBS episodes 9 are now considered successful, which, again, implies a similar rate of success for ERBS (69 percent) as for OS (66 percent). There is no evidence, therefore, to support the view that programs associated with one or the other anchor are generally more successful.

Table 3.

Sample 2: Successful Stabilization Episodes

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Sources: Easterly (1996), IFS, and national sources.

III. Summary and Conclusions

This paper explores whether the distinctive features of ERBS identified in the literature for a group of Latin American countries and Israel also appear in a larger and somewhat different sample. In the construction of this sample, stabilization episodes are identified and timed by applying a simple rule to a data set of annual inflation rates for the period 1960-97 for a group of 143 countries. Additional evidence supporting the notion that the sample indeed contains stabilization episodes, as opposed to simply positive supply shocks, is provided. In order to gauge the robustness of the results, an alternative sample constructed by Easterly (1996) is also used.

The results are not totally supportive of the ERBS syndrome described in the literature. There is no evidence of a “recession now vs. recession later” trade-off between ERBS and OS; in fact, growth performance during stabilization is good under both anchors, as had been found by Easterly (1996). There appears to be a distinctive consumption boom during ERBS, but not an investment boom; investment seems to recover more sluggishly after ERBS than in other stabilization programs. The real exchange rate does appreciate following ERBS and depreciate in other cases, but these movements are not statistically significant. The current account does not exhibit a clear trend in post-stabilization years. There is also no evidence that fiscal discipline is enhanced by the adoption of an exchange rate anchor, or that there are any systematic differences in the records of success of ERBS and OS.

The results of this paper seem to warrant formal testing of various hypotheses related to the effects of inflation stabilization. For example, the fact that in several instances there are substantial differences between ERBS and OS not only in post-stabilization but also in pre-stabilization years may suggest that the selection of a nominal anchor is in itself an endogenous phenomenon—as has already been suggested elsewhere. This would shed some light on the potential role of initial conditions as determinants of post-stabilization dynamics. The effect on growth performance during disinflation of the pre-existing level of inflation, or of the duration of high inflation, also deserves attention. And, of course, several of the elements of the ERBS syndrome need to be reexamined in a context that explicitly accounts for other phenomena and uses a larger control group than the one that has been typically used.

Finally, the data do not provide strong indications that the rules used for selecting a sample of stabilization episodes has systematically timed stabilization episodes incorrectly. There is only weak evidence supporting the view that inflation stabilization is found to be expansionary just because the “dirty work” of macroeconomic correction, in the form of correction of external imbalances, may have preceded inflation stabilization by a year or two. Further work with higher frequency data is needed, however, to deepen our understanding of the dynamics of disinflation under different nominal anchors.19

APPENDIX I

Sources of Data

The IMF′s International Financial Statistics (IFS) was the main source of data for all variables, except for the current account and the real exchange rate. Current account data from the IMF′s World Economic Outlook (WEO) database was used, except for one case (Brazil 1963-69) where, due to the lack of data on the current account, trade balance data from IFS had to be used. In several instances, data from national sources were needed to fill some gaps (especially in the oldest episodes), or when IFS data contained breaks (typically in the case of the population variable, which was needed to compute GDP per capita). The fiscal data refers to the central government. For the real exchange rate, a multilateral real effective exchange rate variable was available from an IMF internal database from 1980 onwards. For countries for which this variable was not available, or in cases where data prior to 1980 was needed, a bilateral real exchange rate vis-à-vis the U.S. dollar was constructed.

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*

The author would like to thank Timothy Lane, Enrica Detragiache, Martin Uribe, and an anonymous referee for their helpful comments, and Sibabrata Das for valuable research assistance.

1

The main stylized facts of ERBS were identified by Kiguel and Liviatan (1992) and Vegh (1992). Calvo and Vegh (1994) and Reinhart and Vegh (1994) lend further support to the notion of an ERBS syndrome.

3

For example, a control group of only six MBS programs is used in Kiguel and Liviatan (1992) and five MBS programs in Calvo and Vegh (1994) and Reinhart and Vegh (1994).

4

A key assumption made in the papers that try to explain the ERBS syndrome is that the selection of the nominal anchor is an exogenous decision. While this paper does not test formally the hypothesis that anchor selection may be endogenous, it tries to shed some light on the issue by trying to identify systematic differences in the behavior of key macroeconomic variables in pre-stabilization years.

5

This represents a sub-set of countries for which the IMF publishes data which excludes the eastern European countries and the former republics of the Soviet Union.

6

Even in those cases, other stabilization policies may have been put in place before the announcement of a path for the exchange rate, thus obscuring the timing of stabilization.

7

The following episodes were identified but are not included in Table 1: Nicaragua 1981 (as a large share of prices were controlled by the government); and Afghanistan 1992, Equatorial Guinea 1986, Guinea Bissau 1982, and Somalia 1991 (either because of unreliable inflation data or lack of data on other variables also studied in this paper).

8

Strictly speaking, the rule produced 28 episodes. Six additional episodes, denoted by italics in Table 1, were identified when the threshold was lowered to 35 percent in an attempt to capture “near misses.” This exercise was also carried out for Criteria (3) and (4).

9

The reason for this was the availability of data: there was a relatively large number of countries for which the series of end-of-period inflation rates contained missing observations. As a result, annual average inflation rates were used which, admittedly, will tend to push forward the stabilization date by one year. The significance of this point is discussed later.

10

Since the “stabilization year” is set here as the first year in which a meaningful reduction in inflation takes place, and not as the peak inflation year as in Easterly (1996), dates for Criterion (1) in Table 1 have been adjusted to make them comparable to those obtained for Criteria (2)-(4).

11

Table 1 shows a stabilization date of 1975 for Chile under Criterion (3) and 1977 under Criterion (4). In fact, according to Criterion (3) a “stabilization” occurred every year in Chile in the period 1975-78, but only the first year of this continuum is shown on Table 1. Under Criterion (4) this stabilization period begins in 1977.

12

Due to the absence of current account convertibility, the stabilization programs in Bangladesh 1975 and Ghana 1984 were not considered ERBS.

13

It must be stressed here that Easterly′s (1996) study focuses on growth and, unlike this paper, does not look at the behavior of the other variables associated with the ERBS syndrome. In this sense, Sample 1 is an extension of that used by Easterly.

14

See, for example, the chapter on exchange rate regimes and financial discipline in Aghevli, Khan, and Montiel (1991).

15

Notice that in the cases of inflation and money growth the charts show a transformation, X/(l+X), rather than the actual level of the variable in order to prevent the width of the associated confidence interval from obscuring the changes in the median.

16

The abbreviation “p.p.” is used to denote “percentage points.”

17

This would explain why OS are not found to be recessionary, as would be expected in the case of pure MBS. I am indebted to Martin Uribe for this point. His 1999 paper (see the Reference section) provides a detailed comparison of pure MBS vs. those that allow for an initial remonetization of the economy.

18

The reader will recall that the selection rule underlying Sample 2 requires a reduction of the inflation rate of at least one-quarter.

19

An (admittedly crude) attempt at comparing the dynamics of interest rates between ERBS and OS was made, using monthly data for the stabilization year. This exercise revealed no clear differences in the behavior of real interest rates across stabilization strategies: real (deposit or T-bill) interest rates exhibited no trend during the year; were somewhat more volatile in the case of OS; and averaged about 4 percent in ERBS vs. 0.25 percent in OS, but this difference was not statistically significant.

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Cover IMF Staff Papers
IMF Staff Papers, Volume 48, No. 1
Author:
Mr. Robert P Flood
Volume/Issue:
Volume 2001: Issue 003
Publisher:
International Monetary Fund
ISBN:
9781451974614
ISSN:
1020-7635
Pages:
232
DOI:
https://doi.org/10.5089/9781451974614.024
Figure 1.

Sample 1: Inflation, Monetary and Fiscal Accounts
Figure 2.

Sample 2: Inflation, Monetary and Fiscal Accounts
Figure 3.

Sample 1: Growth of GDP and Per Capita GDP During Disinflation
Figure 4.

Sample 2: Growth of GDP and Per Capita GDP During Disinflation
Figure 5.

Private Consumption During Disinflation

(In percent of GDP)
Figure 6.

Investment During Disinflation

(In percent of GDP)
Figure 7.

The Current Account During Disinflation

(In percent of GDP)
Figure 8.

The Real Exchange Rate During Disinflation

(Value in year t= 100)
Figure 9.

International Reserves During Disinflation

(In months of imports)