The choice of exchange rate regime is a perennial issue faced by emerging markets. Conventional wisdom, especially after the emerging markets crises of the late 1990s, was the bipolar prescription: countries should choose between either floats (the soft end of the prescription) or hard pegs (monetary union, dollarisation, currency board). The thinking was that intermediate regimes (conventional pegs, horizontal bands, crawling arrangements, managed floats) left countries more susceptible to crises.
While the arguments in favour of free floats are well known, it is less clear why hard pegs – the least flexible regime – should be equally resilient to crisis. Certainly the experience of emerging Europe and some Eurozone countries during the global financial crisis suggests that hard pegs may be more prone to growth declines and painful current account reversals, in which case the hard end of the bipolar prescription may be largely illusory.
But the soft end of the prescription is also murky. An often-overlooked question is what constitutes a ‘safe’ float – that is, where to draw the line between floats and riskier managed (intermediate) exchange rate regimes. Although occasional intervention during periods of market turbulence or extreme events does not turn a float into an intermediate regime, there remains the question of how much management of the exchange rate is too much. This is the policy question confronting many emerging markets central banks, an increasing number of which have switched to ‘managed floats’ – i.e., regimes where the central bank does not (at least explicitly) target a particular parity – as they decide in real time how (or whether) to respond to various shocks. In fact, the trend of ‘hollowing out of the middle’ – countries abandoning intermediate (mostly in favour of free floats) – that began in the immediate aftermath of the Asian financial crisis in 1997-98 came to an end around 2004. Since then, the proportion of intermediate exchange rate regimes has risen, mainly because of the increased adoption of managed floats (Figure 1).
Figure 1. Distribution of exchange rate regimes in emerging markets, 1980-2011 (percent)
Source: Based on IMF's AREAER.
Note: Fixed=hard pegs; Intermediate=pegs to single currency, basket pegs, horizontal band, crawling peg/band, and managed floats; Float=independent floats.
The existing literature provides limited, and generally contradictory, guidance on how much management of the exchange rate is too much. In his seminal work, Fischer (2001, 2008) put ‘managed floats’ with free floats – that is, at the safe pole – rather than with the risky intermediate regimes. But most other studies (e.g., Obstfeld and Rogoff 1995, Frankel 1999, Masson 2000, Rogoff et al. 2004), adopt a more extreme version of the bipolar view, lumping managed floats with other intermediate exchange rate regimes. Rogoff et al. (2004), for example, find that managed floats are significantly more prone to financial crisis than free floats, arguing that emerging markets would benefit from ‘learning to float’. Similarly, Obstfeld and Rogoff (1995) argue that there is little, if any, comfortable middle ground between floating rates and the adoption of a common currency.
In a recent paper (Ghosh et al., 2014), using data for 50 emerging markets covering both the pre- and post-global financial crisis years (1980-2011), we revisit the bipolar prescription that EMs should avoid intermediate exchange rate regimes, and examine two related questions:
- Does the bipolar prescription still hold in the sense that the extremes are safer than the middle?
- And, at the flexible end, where should the line between safe floats and risky managed regimes be drawn?
For our analysis, we go beyond the usual three-way fixed, intermediate, and float categorisation, and adopt a disaggregated de facto classification based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, which allows us to differentiate among the various intermediate exchange rate regimes. However, we also supplement our analysis with some other popular classifications (such as the IMF’s de jure and Reinhart and Rogoff’s (2004) de facto classifications). For each regime, we examine the underlying vulnerabilities (macroeconomic imbalances, financial-stability risks) and the frequency of banking, currency, sovereign debt, and growth crises.
Regimes, vulnerabilities, and crisis susceptibility
A look at the raw data suggests that when it comes to financial and macroeconomic vulnerabilities (rapid credit expansion, excessive foreign borrowing, foreign currency (FX)-denominated domestic currency lending, currency overvaluation, and current account deficits), less flexible intermediate regimes (especially single currency pegs, bands, and crawls) are significantly more vulnerable than pure floats — but so are hard pegs (Figure 2). While intermediate exchange rate regimes appear to be the most susceptible to banking or currency crisis, the vulnerabilities under hard pegs tend to be manifested in growth collapses — perhaps because the high cost of exiting the regime makes the authorities reluctant to abandon it, opting instead for long and painful adjustment.
Figure 2. Vulnerabilities and crisis in emerging markets
Notes: Credit expansion defined as 3-year cumulative change in private sector credit to GDP (in percentage points); Foreign borrowing is bank foreign liabilities (in percent of GDP); FX lending is bank loans in foreign currency (in percent of total bank loans); REER deviation is deviation of REER from trend (in percent of trend); Fiscal deficit is general govt. net borrowing (in percent of GDP); CA deficit is current account deficit (in percent of GDP); Crisis probability is in percent of exchange rate regime observations (where the source of bank, currency and sovereign debt crisis is Laeven and Valencia (2012), and growth crisis are defined as those that are in the bottom fifth percentile of growth declines (current year relative to the average of the last 3 years)).
Our formal empirical analysis confirms these observations, and we find that:
- Intermediate exchange rate regimes as a class are the most susceptible to banking and currency crisis, although managed floats – a subclass within intermediate regimes – behave much more like pure floats, with significantly lower risks and fewer crises.
- Although not especially susceptible to banking or currency crises, hard pegs are significantly more prone to growth collapses than floats.
- The difference across regimes in the susceptibility to sovereign debt crisis is, however, statistically insignificant.
In broad brush terms, a similar picture is obtained using alternative regime classifications, though there are some differences, notably for the ‘managed float’ category. For example, using the de jure classification, managed floats have a statistically significantly higher probability of banking crisis than pure floats, while with Reinhart and Rogoff’s classification, they are significantly more likely to experience debt and banking crises than pure floats. These findings – which show that managed floats of other classifications imply a risky exchange rate regime, whereas managed floats based on the IMF’s de facto classification are almost as safe as pure floats – suggest that different classifications are capturing different regimes under the rubric of managed floating – an admittedly nebulous category. We therefore need to go beyond ‘canned’ classifications and instead identify the more crisis prone regimes in terms of their primitive characteristics, such as nominal exchange rate flexibility and degree, direction, and circumstances of FX intervention.
Where to draw the line?
To delve deeper into what constitutes more risky management of the exchange rate, we use an innovative decision-theoretic technique, known as binary recursive tree analysis that allows for arbitrary thresholds and interactive effects among the explanatory variables in predicting a binary variable (which in our case is banking or currency crisis). The results suggest that there is no simple dividing line (for example, based on exchange rate flexibility) between safe and risky intermediate exchange rate regimes. Rather, what determines whether an intermediate regime is safe or risky, is a complex confluence of factors, including financial vulnerabilities, exchange rate flexibility, degree of intervention and, most important, whether the currency is overvalued. Furthermore, it is not central bank intervention per se that makes the regime risky. On the contrary, if the real exchange rate is overvalued, intervention to prevent (further) overvaluation can reduce the risk of crisis, whereas intervention to defend an overvalued exchange rate makes the regime more crisis prone.
The upshot of our analysis is that consistent with the bipolar prescription, free floats are indeed the least vulnerable to crisis, but at the other end of the spectrum, hard pegs exhibit some of the greatest financial and macroeconomic vulnerabilities, which typically translate into growth collapses. The security of the hard end of the bipolar prescription is thus largely illusory. Nevertheless, inasmuch as emerging markets central banks prefer at least some management of their exchange rates – presumably because of concerns about competitiveness or the balance sheet effects of sharp depreciations under floating exchange rates – simply counselling that the exchange rate should be as flexible as possible and that the central bank should minimise its interventions may not be sufficient to prevent crisis. Rather, what differentiates safe from risky managed regimes is a complex set of factors, including how the central bank manages the exchange rate (defending or preventing overvaluation), and whether it has other instruments (such as macroprudential measures) that can be deployed to mitigate financial stability risks.
Disclaimer: The views expressed herein are those of the authors, and should not be attributed to the IMF, its Executive Board, or its management.
Fischer, S. (2001), “Exchange Rate Regimes: Is the Bipolar View Correct?” Journal of Economic Perspectives, 15(2), 3-24.
Fischer, S. (2008) “Mundell-Fleming Lecture: Exchange Rate Systems, Surveillance, and Advice,” IMF Staff Papers, 55(3), 367-383.
Frankel, J. (1999), “No Single Currency Regime is Right for All Countries or at All Times,” NBER Working Paper 7338 (Cambridge, MA: National Bureau of Economic Research).
Ghosh, A. R., J. D. Ostry, M. S. Qureshi (2014), “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF Working Paper No. WP/14/11 (Washington DC: International Monetary Fund).
Laeven, L., and F. Valencia (2012), “Systemic Banking Crises Database: An Update,” IMF Working Paper No. WP/12/163 (Washington DC: International Monetary Fund).
Masson, P. (2000), “Exchange Rate Regime Transitions,” IMF Working Paper WP/00/134 (Washington DC: International Monetary Fund).
Obstfeld, M., and K. Rogoff (1995), “The Mirage of Fixed Exchange Rates,” Journal of Economic Perspectives, 9(4), pp. 73-96.
Reinhart, C., and K. Rogof (2004), “The Modern History of Exchange Rate Arrangements: A Reinterpretation,” Quarterly Journal of Economics, 119(1), pp. 1-48.