“We also agreed that an orderly unwinding of global imbalances, while sustaining global growth, is a shared responsibility involving... greater exchange rate flexibility...”
G20 Communiqué, Meeting of Finance Ministers and Central Bank Governors, Cape Town, South Africa, November 17-18, 2007.
The idea that greater exchange rate flexibility leads to more rapid current account adjustment is repeated so often that it appears to be a truism. This has become a new mantra that the International Monetary Fund is teaching to its member countries, a strategy endorsed as “based on sound economic principles” by John Taylor (2006). Yet, we believe, this view does not stand up against a careful look at the facts.
We approach the question posed in the title by empirically examining whether the pace at which a country’s current account balance adjusts to its average value depends upon its exchange rate regime, such as a freely floating currency, a dirty float, a crawling peg, or a fixed rate (Chinn and Wei 2008). We also test to see if the results we obtain are sensitive to alternative exchange rate regime classifications, to the selection of country groups, and to the statistical methods employed.
We find no robust evidence that the speed of current account adjustment increases with the degree of flexibility of an exchange rate regime. To be more precise, there is some evidence that, for non-oil developing countries, the most rigid fixed regimes have the fastest current account adjustment, followed by pure floaters. Countries with a dirty-float exchange rate regime exhibit the slowest current account adjustment.
Devil in the details
How do we come to these conclusions? Using a large data set spanning 170 countries over the 1971-2005 period, we pool the data and estimate regressions of the current account on a single lag of itself, interacting dummy variables for de facto exchange rate regimes. We assume current account balances follow a first order autoregressive process, an assumption which appears reasonable for annual data (see Chinn and Prasad 2003). In the statistical analysis, we also control for openness to trade (the sum of exports and imports, normalised by GDP) and openness to capital flows (the Chinn-Ito index of financial openness). The data are drawn from the World Bank’s, World Development Indicators, with the real effective exchange rates from the IMF's International Financial Statistics. The exchange rate regime data are from Levy-Yeyati and Sturzenegger (2003) (cross-checked and confirmed with data from Reinhart and Rogoff 2004).
What are the statistical results? We note that higher coefficients on the lagged current account balance (the “autoregressive coefficient”) represent greater persistence (or slower adjustment). Hence, the lower the autoregressive coefficient, the faster current account balances revert to mean. The priors associated with conventional wisdom – and hence advice to developing countries with large current account imbalances to move to more flexible exchange rates – would suggest monotonically higher autoregressive coefficient estimates as one moves from more flexible to more rigid regimes.
Because most policy debates have focused on the choices by countries like China and Saudi Arabia, we focus our discussion on the results pertaining to the less developed countries (LDCs) and the LDCs excluding oil exporters. Figure 1 shows the autoregressive coefficients for the non-industrial country sample (blue bars) and non-industrial minus oil exporters sample (red bars), moving in the direction of lower exchange rate flexibility.
Figure 1. Current account persistence
Note: First order autoregressive coefficient estimates for current account to GDP ratios estimated in pooled OLS regressions on non-industrial country sample (blue bars) and non-industrial ex oil sample (red bars), stratified by Levy-Yeyati and Sturzenegger classifications. Larger numbers indicate a slower current account adjustment. Source: Chinn and Wei (2008).
One obvious question is how trade and financial openness might affect the degree of current account flexibility – if we omitted these factors and they in turn were correlated with the choice of exchange rate regime, we might mistakenly attribute a correlation to regimes that more properly should be attributed to openness. We address this concern by including trade openness and financial openness variables in the regression in such a way that the average size of the current account balance and the pace of current account adjustment can vary with the degree of openness. The pace of adjustment, allowing for these effects, is shown in Figure 2.
Figure 2. Current account persistence, controlling for openness
Note: First order autoregressive coefficients for current account to GDP ratios estimated in pooled OLS regressions (including trade and financial openness variables) on non-industrial country sample (blue bars) and non-industrial excluding oil exporters sample (red bars), stratified by Levy-Yeyati and Sturzenegger classifications. Larger numbers indicate a slower current account adjustment. Source: Chinn and Wei (2008).
Countries with the most tardy current account adjustment are in the dirty float/crawling peg category. Indeed, excluding oil exporters, the fixed regime exhibits the least current account persistence, and definitely less than the dirty float/crawling peg regime.
Let’s huff and puff: How sturdy and robust are the results?
We consider the sensitivity of the results along a set of dimensions. First, we consider size. Larger countries exhibit slower current account reversion, when compared to smaller economies (as measured by PPP GDP). However, if there is any effect from fixed exchange rates, it is that fixed rate countries exhibit faster reversion. Interestingly, when we stratify by G-7 versus non-G-7 countries, we find a similar pattern for non-G-7 countries – faster reversion under fixed rates.
Astute readers will observe that we take the de facto exchange rate regime as exogenous. However, one could plausibly argue that the selection of exchange rate regime is a dependent on the ease with which the current account adjusts. Alternatively, the exchange rate regime and the rate of reversion could both be affected by a common factor that we have failed to account for.
In order to address this possibility, we use a two-stage instrumental variables procedure to deal with potential endogeneity issues. Specifically, we estimate a probit model, which treats the exchange rate regime as a binary variable (e.g., either floating or not floating), and using as determinants the variables suggested by Levy-Yeyati and Sturzenegger (2003): economic size, land area, island dummy, initial foreign exchange reserves, as well as a regional factor (in LYS, it's the average exchange rate regime for the region; we just use regional dummies).
Using the predicted exchange rate regimes, we find that accounting for endogeneity of this sort does not change the results. Exchange rate regimes do not affect the pace of reversion in a statistically significant fashion. See Chinn and Wei (2008) for further details.
Policy prescription should not be a faith-based initiative
How do these findings inform the ongoing debate about Chinese adjustment? As one of us has discussed in a previous VoxEU column, a more rapid pace of real exchange rate appreciation might be beneficial to China – in terms of inflation stabilisation and external balance adjustment – as well as to the world economy. However, exchange rate appreciation is a logically separate point from greater exchange rate flexibility. And greater exchange rate flexibility is in turn logically separate from more rapid current account adjustment.
The conventional wisdom on the benefits of exchange rate flexibility for current account adjustment is greatly exaggerated. The fact that policymakers are basing their prescriptions upon unverified propositions lends even greater urgency to a comprehensive rethinking of the flexibility dogma.
Chinn, Menzie D. & Prasad, Eswar S., 2003. "Medium-term determinants of current accounts in industrial and developing countries: an empirical exploration," Journal of International Economics, Elsevier, vol. 59(1), pages 47-76, January.
Chinn, Menzie and Shang-Jin Wei, 2008, “A Faith-based Initiative: Does a Flexible Exchange Rate Regime Really Facilitate Current Account Adjustment?”, NBER Working Paper 14420.
Levy-Yeyati, E. and F. Sturzenegger, 2003, “A de facto Classification of Exchange Rate Regimes: A Methodological Note,” mimeo
Reinhart, C.M. and K. Rogoff, 2004, “The Modern History of Exchange Rate Arrangements: A Reinterpretation,” Quarterly Journal of Economics 119(1)(February 2004): 1-48
Taylor, J.B., 2006. “Economic Reform and the Current Account: Implementing the Strategy.” Comments at 21 April 2006 IMF conference.