Exchange Rate Policies and Economic Development
- Eduardo Levy YeyatiEduardo Levy YeyatiSchool of Government, Torcuato di Tella University; School of Economics, University of Buenos Aires
While traditional economic literature often sees nominal variables as irrelevant for the real economy, there is a vast body of analytical and empirical economic work that recognizes that, to the extent they exert a critical influence on the macroeconomic environment through a multiplicity of channels, exchange rate policies (ERP) have important consequences for development.
ERP influences economic development in various ways: through its incidence on real variables such as investment and growth (and growth volatility) and on nominal aspects such relative prices or financial depth that, in turn, affect output growth or income distribution, among other development goals. Additionally, ERP, through the expected distribution of the real exchange rate indirectly, influences dimensions such as trade or financial fragility and explains, at least partially, the adoption of the euro—an extreme case of a fixed exchange rate arrangement—or the preference for floating exchange rates in the absence of financial dollarization. Importantly, exchange rate pegs have been (and, in many countries, still are) widely used as a nominal anchor to contain inflation in economies where nominal volatility induces agents to use the exchange rate as an implicit unit of account. All of these channels have been reflected to varying degrees in the choice of exchange rate regimes in recent history.
The empirical literature on the consequences of ERP has been plagued by definitional and measurement problems. Whereas few economists would contest the textbook definition of canonical exchange rate regimes (fixed regimes involve a commitment to keep the nominal exchange rate at a given level; floating regimes imply no market intervention by the monetary authorities), reality is more nuanced: Pure floats are hard to find, and the empirical distinction between alternative flexible regimes is not always clear. Moreover, there are many different degrees of exchange rate commitments as well as many alternative anchors, sometimes undisclosed. Finally, it is not unusual that a country that officially declares to peg its currency realigns its parity if it finds the constraints on monetary policy or economic activity too taxing. By the same token, a country that commits to a float may choose to intervene in the foreign exchange market to dampen exchange rate fluctuations.
The regime of choice depends critically on the situation of each country at a given point in time as much as on the evolution of the global environment. Because both the ERP debate and real-life choices incorporate national and time-specific aspects that tend to evolve over time, so does the changing focus of the debate. In the post-World War II years, under the Bretton Woods agreement, most countries pegged their currencies to the U.S. dollar, which in turn was kept convertible to gold. In the post-Bretton Woods years, after August 1971 when the United States abandoned unilaterally the convertibility of the dollar, thus bringing the Bretton Woods system to an end, the individual choices of ERP were intimately related to the global and local historical contexts, according to whether policy prioritized the use of the exchange rate as a nominal anchor (in favor of pegged or superfixed exchange rates, with dollarization or the launch of the euro as two extreme examples), as a tool to enhance price competitiveness (as in export-oriented developing countries like China in the 2000s) or as a countercyclical buffer (in favor of floating regimes with limited intervention, the prevalent view in the developed world). Similarly, the declining degree of financial dollarization, combined with the improved quality of monetary institutions, explain the growing popularity of inflation targeting with floating exchange rates in emerging economies. Finally, a prudential leaning-against-the-wind intervention to counter mean reverting global financial cycles and exchange rate swings motivates a more active—and increasingly mainstream—ERP in the late 2000s.
The fact that most medium and large developing economies (and virtually all industrial ones) revealed in the 2000s a preference for exchange rate flexibility simply reflects this evolution. Is the combination of inflation targeting (IT) and countercyclical exchange rate intervention a new paradigm? It is still too early to judge. On the one hand, pegs still represent more than half of the IMF reporting countries—particularly, small ones—indicating that exchange rate anchors are still favored by small open economies that give priority to the trade dividend of stable exchange rates and find the conduct of an autonomous monetary policy too costly, due to lack of human capital, scale, or an important non-tradable sector. On the other hand, the work and the empirical evidence on the subject, particularly after the recession of 2008–2009, highlight a number of developments in the way advanced and emerging economies think of the impossible trinity that, in a context of deepening financial integration, casts doubt on the IT paradigm, places the dilemma between nominal and real stability back on the forefront, and postulates an IT 2.0, which includes selective exchange rate interventions as a workable compromise. At any rate, the exchange rate debate is still alive and open.
Exchange Rate Policies: The Context Matters
Exchange rate policies (ERP) influence, to a great extent, key elements of the macroeconomic environment in which the economy operates; hence its relevance to development objectives. The first element that comes to mind when talking about ERP and development is real per capita output growth: there is a large body of work that has examined the direct link between growth and output volatility, on the one hand, and the exchange rate level and volatility, on the other. However, the choice of ERP also has direct implications on the evolution of nominal aspects, such as relative prices or financial depth, that in turn affect, for example, output growth or income distribution, among other development goals. Additionally, it indirectly influences dimensions such as trade or financial fragility; it is these relations that explain, for example, why the adoption of the euro—an extreme case of a fixed exchange rate arrangement—was predicated on its potential trade gains, or why the preference for floating exchange rates is often argued on the need to avoid speculative currency attacks. Finally, exchange rate pegs have been (and, in many countries, still are) widely used as a nominal anchor to contain inflation in economies where nominal volatility induces agents to use the exchange rate as an implicit unit of account.
All of these channels previously described have been reflected to varying degrees in the choice of exchange rate regimes in recent history. It is not surprising then, that the regime of choice depends critically on the situation of each country at a given point in time as well as on the evolution of the global environment, At the national level, high inflation would strengthen the case for a peg; deeper trade integration would tilt the balance in favor of a common currency; and exposure to real external shocks would argue for a float. Similarly, at the global level, the decline in global inflation and the deepening of financial integration in the world may call for more flexible arrangements. Thus, because both the ERP debate and its actual implementation incorporates both country- and time-specific aspects that tend to evolve over time, as conditions in individual economies and the global financial markets changed, so did the focus of the debate. To understand how this debate maps to actual policy, history matters. In the post-World War II years, under the Bretton Woods agreement, most countries pegged their currencies to the U.S. dollar, which in turn was kept convertible to gold. In the post-Bretton Woods years—after August 1971, when the United States abandoned unilaterally the convertibility of the dollar, bringing the Bretton Woods system to an end—the individual choice of ERP was intimately related to the global and local historical context: No single policy was preferred for all countries at all times (Frankel, 1999).
In addition, any empirical exploration of the links between exchange rates and development requires a taxonomy of ERP, a task that in practice has been plagued by definitional and measurement problems that makes any particular definition and grouping rather controversial. Few economists would contest the textbook definition of canonical exchange rate regimes: Fixed regimes involve a commitment to keep the nominal exchange rate at a given level (typically, through central bank purchases and sales of foreign currency); floating regimes imply no market intervention by the monetary authorities and therefore an exchange rate that moves according to market forces to find its equilibrium (which could tautologically be defined as that induced by market forces in the absence of intervention). Reality is much more nuanced. Textbook floats are often hard to find, and the empirical distinction between alternative flexible regimes is not always clear. Moreover, there are many different degrees of exchange rate commitments as well as many alternative anchors, sometimes undisclosed. To complicate matters further, policies often tend to differ significantly from declared intentions. It is not unusual that a country that officially declares to peg its currency realigns its parity if it finds the constraints on monetary policy or economic activity too taxing. By the same token, a country that commits to a float may choose to intervene in the foreign exchange market to dampen exchange rate fluctuations. At any rate, a critical element in any practical discussion of the implications of ERP requires a methodological characterization of exchange rate regimes.
Classifying Exchange Rate Policies
Since the late 1990s, exchange rate regime groupings moved from the standard de jure approach implicit in the traditional IMF’s regime classification (which reproduced the regimes officially informed by the countries’ monetary authorities and was discontinued in 2000; see Ghosh, Gulde, & Wolf, 2003) to a de facto definition based on the observed behavior of the relevant variables, most notably the exchange rate and the stock of reserves.
A key question when assessing alternative classifications is to what extent they capture appropriately the nature of exchange rate policies (ERP) as opposed to the statistical behavior of exchange rates. Many recent classifications have largely relied on the volatility of nominal exchange rates either to group economies (Shambaugh, 2004) or to revise de jure regimes (Ilzetzki, Reinhart, & Rogoff, 2017), paying little attention to the extent of policy intervention. As a result, countries with large movements in nominal exchange rates are typically classified as floats regardless of whether the authorities make efforts to reduce exchange rate volatility; conversely, stable countries with little volatility are often classified as pegs in spite of little or no intervention. Levy Yeyati and Sturzenegger (2005) attempt to mitigate this bias by comparing the variability of exchange rates with that of international reserves, following the textbook analysis according to which fixed regimes should display relatively less volatility in the nominal exchange rate than that in reserves.
The vast body of empirical results regarding the drivers and implications of alternative exchange rate regimes should be taken with caution, as there remain many pending issues in existing classifications, including:
The choice of the reference currency to compute the relevant exchange rate: While often trivial to define, in many cases the reference currency is unclear (e.g., does the Swiss National Bank look to the euro or to the dollar when thinking of its monetary policy?) or explicitly hidden (e.g., in pegs to an undisclosed currency basket).
The treatment of monetary unions: Should members be characterized as fixers (vis-à-vis other union members) or as floaters (vis-à-vis the rest of the world)?
Black markets versus official exchange rates: While this issue is today rather marginal, as the importance of parallel markets has declined over time, it was prevalent in the early post-Bretton Woods years when the presence of a liquid parallel market cast doubts on the economic relevance of the official exchange rate.
Nontraditional forms of intervention: This has become important in the late 2010s, as the intervention in the exchange market by fiscal authorities, the use of derivatives (such as currency swaps or forwards), or even “verbal” intervention via official comments or warnings are increasingly used but hard to incorporate into (and therefore largely ignored by) available classifications.
Peg heterogeneity: Peg regimes include a wide array of alternatives: “conventional” pegs to a currency (or currency basket), currency board agreements that eliminate autonomous monetary policy by restricting the central bank to back monetary liabilities with liquid international reserves (Enoch & Gulde, 1998), de jure “dollarization,” which usually denotes the adoption of a foreign currency as legal tender (Levy Yeyati & Sturzenegger, 2002), or monetary unions where several countries share one common currency that may float (as in the Eastern Caribbean and African currency unions) or peg to another currency (as in the European Monetary Union). The economic implications of each of these regimes, which are often bunched under the peg group, are predictably different.
Why Is ERP Important for Development?
There is a vast literature on the impact of exchange rate policies (ERP) on economic variables, including direct effects on some development policy objectives (e.g., the use of exchange rate anchors to contain inflation, or the benefits of exchange rate flexibility to smooth out the output response to real shocks) and indirect effects via connections with variables that are not development objectives themselves but are known to facilitate them (e.g., the link between exchange rate stability and trade, or financial depth).1 In what follows, a summary is provided of what is known of these direct and indirect impacts.
ERP and Growth
Several hypotheses have been presented on why the regime may be related to growth. Some channels have to do with global factors and others with domestic ones. From a global perspective, fixed exchange rates were viewed as one of the important drivers behind the development of international financial markets at the end of the 19th century (Johnson  provides an early defense). Later on, the Mundellian paradigm shifted the attention to domestic factors by focusing on the shock absorber role of exchange rates and the finding that fixed regimes tend to magnify real shocks. This, in turn, to the extent that volatility deters long-run growth, implies that fixed regimes are likely to deliver a weaker economic performance (Gavin & Hausmann, 1996; Ramey & Ramey, 1995; Aizenman & Marion, 1999; Caballero, 2000). Others have suggested that fixed exchange rates tend to create exchange rate misalignments that lead to speculative attacks and sharp crises, resulting over the years in lower growth performance: Here, the growth effect comes from a higher propensity to suffer an economically costly crisis event (Aizenman & Glick, 2005; Kuttner & Posen, 2001). A somewhat related story is offered by Hausmann and Rigobon (2003), who argue that the volatility of exchange rates may induce an under-specialization in tradables, which may hurt growth. Empirically, while ERP is often found not to have significant growth effects in industrial countries, in developing economies results are mixed. Levy Yeyati and Sturzenegger (2001, 2003) find that floating leads to higher growth, while Rogoff, Husain, and Mody (2005) report that this result applies only to advanced economies. To reconcile these results, one could think of the limitations of existing regime classification. For example, because ERP flexibility is usually proxied by the volatility of the exchange rate, peg failures, including currency crises, are often recorded as intermediates or floats (despite the fact that, in those episodes, ERP is no longer a policy choice), whereas stable floats are often coded as intermediate or pegged regimes.
The analytical economic literature has also emphasized the link between growth and the level of the exchange rate; in particular, the growth benefits of an undervalued exchange rate: Eichengreen (2006a, 2006b) argue that the undervalued exchange rates implemented by the Bretton Woods agreement were a key driver of Europe’s recovery in the postwar period; Ohkawa and Rosovksy (1973) made the point for Japan’s post-World War II recovery. This mercantilist view, namely that a temporarily undervalued currency could be used to protect infant industries as a development strategy, has recently enjoyed a minor revival (Hausmann & Rodrik, 2003; Guzmán, Ocampo, & Stiglitz, 2017). Empirically, Hausmann, Pritchett, and Rodrik (2005) find a depreciated real exchange rate to be an important component of growth accelerations; conversely, Johnson, Ostry, and Subramanian (2006) show that persistent overvaluations tend to be associated with poorer growth. Rajan and Subramanian (2005) claim that an overvaluation explains the “Dutch disease” effect of foreign aid, and Prasad, Rajan, and Subramanian (2006) do the same for the disappointing growth dividends of financial integration, Finally, Levy Yeyati, Sturzenegger, and Gluzmann (2013) document, for developing economies, a positive correlation between intervention (and the resulting currency depreciation) and savings and investment (and, in turn, growth)—a result in line with the findings of Habib, Mileva, and Stracca (2016) and Goncalves y Rodrigues (2017).
Perhaps the most traditional and less controversial link to growth is given by the relation between exchange rate flexibility and output volatility, more specifically, to the role played by the exchange rate as shock absorber: Under floating exchange rates, the economy has a greater ability to adjust to real external shocks, a view that goes back to Meade (1951) and Friedman (1953). Standard tests of this link find that a more flexible regime attenuates the output response to shocks: In particular, if nominal prices are downward inflexible, the output response to negative real shocks should be more muted under floating regimes (Edwards & Levy Yeyati, 2005; Broda, 2001), mostly for developing countries. In the same direction, the evidence shows that emerging economies with flexible regimes exhibit lower output volatility (Levy Yeyati & Sturzenegger, 2003).
ERP on Price Stability
In contexts of high inflation, low credibility, and limited impacts of monetary policy announcements where inflation expectations (and even current prices) tend to adjust with an eye on changes in the exchange rate as a proxy nominal reference, the exchange rate is often used to anchor to inflation and coordinate expectations. Indeed, in high inflation economies, it is not unusual to index prices partially to the exchange rate (typically, vis-à-vis the U.S. dollar); in this case, an exchange rate anchor allows for a quick transition from backward indexation to past inflation, to forward indexation to the announced exchange rate path (Canavan & Tommasi, 1997).
From an empirical perspective, there seems to be agreement on the fact that pegs are associated with lower inflation, even after controlling for money creation (e.g., by adding a peg dummy to a standard monetary equation) (Ghosh et al., 2003; De Grauwe & Schnabl, 2005). This suggests that countries with tighter dollar indexation would benefit the most from the immediate impact of an anchor on inflation expectations—and explains why they were its most active promoters. It also indicates that the effect works through the anchoring of expectations rather than through the imposition of monetary discipline. Intuitively, in the long run, pegs help monetary policy not only by lowering expectations (thereby reducing the growth sacrifice needed to contain prices), but also by disciplining monetary policy. An exchange rate anchor cannot be sustained in the face of inconsistent monetary policy that fuels inflation; this may explain why a closer inspection indicates that only long-lasting pegs are significantly linked to low inflation (Levy Yeyati & Sturzenegger, 2001).
Indirect Links: Integration and Financial Channels
There is a vast body of work on ERP and economic integration (bilateral trade flows and cross-border capital flows, including foreign direct investment). This literature is largely based on the incidence of currency conversion (which includes not only the bid–ask spreads but also currency risk due to potential losses from exchange rate variations) on cross-border multicurrency transaction costs. The empirical findings, mostly based on gravity models, point at a small but positive effect of exchange rate stability on trade (Thursby & Thursby, 1987; De Grauwe, 1988; Parsley & Wei, 2001a, 2002b).
Also based on the gravity model is the evidence of trade effects of a currency union, led by Rose’s (2000) article that estimated a 200% increase in bilateral trade due to the adoption of a common currency, a finding that has since been greatly qualified: More recent estimates using data from the European Monetary Union (EMU) to measure the effect of the adoption of the euro go as low as 5–10% (Micco, Stein, & Ordoñez, 2003), 4% (De Nardis, De Santis, & Vicarelli, 2007), or even 0% (Berger & Nitsch, 2005). Underlying these analyses is the Optimal Currency Area (OCA) premise that a monetary treaty, by preventing competitive devaluations, fosters foreign direct investment and intraindustry trade. The influence of ERP on foreign direct investment (FDI) flows, however, is more scantily documented: For example, De Sousa and Lochard (2004), using data from the European Union, find a link between the adoption of the euro and the increase in intra-EMU FDI flows. There is, in addition, a literature documenting the complementary link between trade and FDI (Clausing, 2000; Svensson, 1997).
ERP has been associated with financial development through three distinct channels. The first one, already mentioned, relates to the implications of exchange rate instability for cross-border flows. A second one refers to domestic markets and documents the costs of nominal instability (moderate to high inflation, even if it is predictable) in terms of the demand for local assets and the deepening of local financial markets (Boyd, Levine, & Smith, 2001; Khan, Senhadji, & Smith, 2006). A third channel points to how exchange rate rigidity (most notably, a pegged regime) favors financial dollarization, where the latter is defined as the use of a foreign currency to denominate financial assets and liabilities held by residents (Levy Yeyati, 2006).
Note that the links connecting ERP with development are further complicated by the fact that the workings of some of these channels change dramatically with specific country characteristics and global conditions. For example, de facto financial integration and capital mobility could foster exchange rate flexibility as they force the country to choose between a stable exchange rate and an autonomous monetary policy; however, if financial flows are denominated in the foreign currency, the concomitant increase in dollar liabilities may optimally inhibit exchange rate flexibility for fear of balance sheet losses in the event of a real depreciation. Similarly, whereas flexible exchange rates help buffer the economy against adverse external shocks, the same channel would be contractionary in heavily dollarized countries, which would be better off with more rigid exchange rate arrangements.
Behind the Choice of ERP: A Historical Account
Tracing the policy debate in the post-Bretton Woods era sheds light on the different intervening factors identified in the literature as justification for alternative exchange rate policies (ERP) and provides a broader perspective to go from the analytical arguments and the empirical results to the actual policy choices. To that end, a brief narrative of the debate, linking different conditions in international financial markets to different “trends” in the choice of regimes in the developing world, is useful to set the stage for addressing more specific policy questions.
The 1980s and 1990s
A casual review of the exchange rate debate in the late 1980s and early 1990s shows how the discussion hinged on the role of exchange rates and income policies as nominal anchors in a high inflation environment (Bruno, Di Tella, Dornbusch, & Fischer, 1988). The academic literature mirrored these concerns, assessing the merits of exchange rate-based stabilizations (ERBS) coupled with income policies relative to the more traditional money-based stabilizations. Kiguel and Liviatan (1991, 1992) and Végh (1992) documented that ERBS appeared to lead to an initial and temporary consumption boom that tended to end in a contraction, whereas money-based stabilizations often induced an initial recession followed by a boom. Calvo and Végh (1993, 1994) provided a formalization: In their model, a one-shot credible stabilization tended to have the same result regardless of the anchor of choice, but transitory or not perfectly credible ERBS lowered interest rates in the short run, fueling a consumption and output boom (and a trade deficit; all of which De Gregorio, Guidotti, & Végh  attribute to the effect of the interest rate collapse on the purchase of durable goods) that reversed once the program collapsed. However, noncredible money-based stabilizations were expected to increase the demand for money, jacking up interest rates in the short run, appreciating the exchange rate, and causing a recession in the short term. Calvo and Végh’s framework provided a fairly strong rationale for ERBS from the perspective of myopic politicians eager to obtain significant short-run effects.
As inflation concerns subsided and financial integration increased in the 1990s, the ERP debate in developing economies shifted the focus to the interplay of two contrasting features of financial development. The first feature was the fact that financial globalization led to a growing ineffectiveness of monetary policy or, more precisely, that capital controls were found to be decreasingly effective as economies became more sophisticated. The second feature was that, starting as in the early years of the 20th century, growing financial integration and sophistication in the developed world strengthened the restrictions imposed by the impossible trinity (the inability to sustain simultaneously three policy objectives: an independent monetary policy, open capital markets, and fixed exchange rates), which were previously avoided due to the absence of de facto financial integration (Obstfeld & Taylor, 2004; Rose, 2006), all of which made floating regimes more attractive. This led naturally to one of the dominant proposals in the late 1990s, the “bipolar” view (Fischer, 2000) that noted that pure flexible exchange rates or superfixed regimes (the so-called hard pegs, such as currency boards or unilateral dollarization) were the only viable alternative for financially integrated developing economies, at the expense of conventional pegs, inherently vulnerable due to monetary policy inconsistencies and self-fulfilling speculative attacks. However, in financially dollarized economies, the risk of balance sheet losses for governments and firms indebted in a foreign currency in the event of a depreciation (the focus of the third-generation models of currency crises popularized in the context of the Asian crisis), led to fear of floating (Calvo & Reinhart, 2002): exchange rate intervention against depreciations in officially floating regimes. Ultimately, to the extent that dollarization made depreciations contractionary (Frankel, 2005), it eliminated the benefits of flexible regimes, making hard pegs the only reasonable option for those countries. Thus, the bipolar view derived naturally into what could be called a “unipolar view” (Calvo 1999, 2000; Barro, 1999; Hausmann, Gavin, Pages, & Stein, 1999; Hausmann, Panizza, & Stein, 2001; Ghosh, Gulde, Ostry, & Wolf, 1997; Dornbusch, 2001), according to which hard pegs were the only sensible option for financially dollarized economies.
By the turn of the century, the failure of Argentina’s currency board to ensure fiscal and monetary discipline cast doubt on the premises underscoring the unipolar view (De la Torre, Levy Yeyati, & Schmukler, 2002; Hausmann & Velasco, 2002). In the same vein, recent research finds hard pegs to be as financial crisis-prone as conventional pegs (Ghosh, Ostry, & Qureshi, 2014). Additionally, the success in building central bank autonomy and monetary credibility, together with the resulting decline in inflation and exchange rate pass-through and an effort to reduce financial dollarization, led to the growing popularity of the float pole of the bipolar view, particularly inflation targeting arrangements that placed the inflation rate, rather than the exchange rate, as the key nominal anchor, an option that recovered autonomous monetary policy.
The 2000s: Floating + Inflation Targeting (FIT)
The declining degree of financial dollarization, combined with the improved quality of monetary institutions, explain the evolution of ERP in recent years. The recent changes in debt composition and policy quality in developing countries have led developing economies to use the inflation rate rather than the exchange rate as the main policy target, leading some observers to salute the combination of floating exchange rates and inflation targeting as a new, possibly more resilient ERP paradigm (Rose, 2006).
Inflation targeting (IT) comes in many varieties, from soft numerical inflation targets (in the form of a wide inflation band) to more sophisticated schemes that include: (a) a legal commitment to price stability as the primary goal of monetary policy; (b) a communication strategy that allows agents to anticipate policy decisions; and (c) direct accountability of the central bank management for attaining the targets (Truman, 2003). From an operational point of view, an inflation targeting regime typically implies identifying an intervention variable, usually a reference interest rate for funds offered by the central bank. This rate is defined and discussed in regular meetings, the proceeds of which are made available to the public, sometimes with a lag. It also implies no active ERP (a “benign neglect” regarding the exchange rate, beyond what has direct implications for future inflation).
Historically, middle-income developing countries adopting IT gradually proceeded from the soft version that in the early years usually coexisted with a dirty exchange rate regime (see Schmidt-Hebbel & Tapia, 2002 for Chile; Armas & Grippa, 2006 for Peru; Fraga, Goldfajin, & Minella, 2003 for Brazil; and Mishkin, 2006) to the more canonical version. Moreover, the introduction of IT in developing countries often coincided with the transition from moderate two-digit to low one-digit inflation—and countries that chose IT exhibited higher initial inflation—so that a sacrifice ratio (typically defined as the output loss associated with a unit percentage change in inflation) in this transition may overstate the net benefits of IT once inflation was brought under control (Mishkin & Schmidt-Hebbel, 2001).
The early empirical literature on the consequences of floating plus inflation targeting (FIT) on development suffers from some important drawbacks: (a) FIT adopts a number of forms that are not always strictly comparable; (b) launched in 1990 by the Bank of New Zealand, it has been adopted in developing countries relatively recently (Chile and Israel led the way in the mid-1990s, although they implemented a fully fledged IT framework only in the 2000s) and, as noted, in times of moderate (two-digit) inflation. Bearing this in mind, a number of recent empirical studies (which often include both industrialized and developing economies) take stock of the IT experience in the world and find no obvious gains for developing economies: IT developing economies enjoy sacrifice ratios and output volatility that are lower than before the adoption of IT, but comparable to those observed in non-IT industrial countries (Cecchetti & Ehrmann, 1999) (Corbo & Schmidt-Hebbel, 2001). Moreover, there is no convincing evidence that they perform better than comparable non-IT developing countries on other fronts: While IT helps bring down inflation (Corbo & Schmidt-Hebbel, 2001), align inflation expectations, and reduce exchange rate pass-through coefficients (Corbo, Landerretche, & Schmidt-Hebbel, 2001), thereby allowing for a more flexible exchange rate, deviations from targets are larger and more frequent than in industrial countries (Fraga et al., 2003). In short, IT has been instrumental in bringing inflation rates to one-digit levels, but once there, its benefits are more difficult to identify.
FIT has had its most severe test to date during the 2007–2008 inflation rollercoaster (Svensson, 2010; Schmidt Hebbel & Carrasco, 2016). Supply shocks unrelated to domestic demand are usually transitory and, for this reason, partially dismissed under the IT framework by targeting an adjusted (core) price index less sensitive to supply swings. However, IT is not prepared to address persistent shocks, such as the increase in international food and energy prices throughout the early 2000s until mid-2008, particularly in developing economies where, because of a lack of central bank credibility, the target was set against the more sensitive but transparent headline inflation, where central banks were forced into a tightening interest rate cycle, even in a context of a cooling economy. Conversely, the deepening of the financial crisis in late 2008 and the ensuing collapse of commodity prices and downbeat growth outlook led central banks to switch back to monetary easing, even before inflation came within the target band, in many cases intervening heavily in the foreign exchange to contain the currency and attenuate the pass-through to prices. This, followed by another upward wave of commodity prices and concerns about spillovers from monetary easing in the advanced economies, has, in the late 2010s, caused a partial reappraisal of FIT as a paradigm for the developing world and, in particular, a partial comeback of active ERP aimed at reducing excess exchange rate swings.
The New Drivers of Active ERP
Active exchange rate policies in the 2000s, in the form of exchange rate intervention and controls, have been attributed to two main motives: a prudential leaning-against-the-wind motive linked with mean reverting exchange rate swings and the propensity to suffer dollar liquidity runs in the downturn, and a “mercantilist” motive aimed at maintaining an undervalued currency as a means to protect the domestic industry from international competitors.
Prudential Versus Mercantilist Motives
Prudential issues certainly play an indirect role in the mercantilist view of intervention: The decline of financial dollarization in the 2000s relaxed the balance sheet concerns behind the fear of floating, recovering the expansionary benefits of a depreciated currency. That notwithstanding, to the extent that currency wars in which countries attempt beggar-thy-neighbor competitive depreciations are hard to sustain in globally integrated markets, the mercantilist view seldom applies, typically so to less financially integrated economies.
The first candidate interpretation of the surge in international reserves in developing economies in the 2000s pointed at prudential considerations; specifically, the fear of a dollar liquidity crunch similar to those crutches that caused the emerging market crises in the second half of the 1990s. In this view, intervention was simply the result of the rapid accumulation of precautionary reserves in the aftermath of a crisis, a type of “self-insurance” that, to some extent, reflects the reluctance to be placed again at the mercy of international financial institutions (Aizenmann & Lee, 2005; Aizenmann & Marion, 2004). However, it was argued that in many cases the stock of reserves went beyond what would be justified by self-insurance (Summers, 2006; Rodrik, 2006b) and that some additional motivations were missing.
More recently, the empirical evidence has favored an alternative prudential motive, which explains foreign exchange intervention as an exchange rate (rather than a reserve) policy objective. Leaning against the appreciation wind during expansions may be regarded as the countercyclical prudential response to procyclical capital inflows, with the view to attenuating transitory (and possibly excessive) misalignments and limiting the country’s external vulnerability during the recessive phase (Caballero & Lorenzoni, 2006). In that sense, intervention could be justified as a tool to smooth out excessive exchange rate volatility without having any specific target level, a view that transpires from the actual intervention narratives of central banks (Bank of International Settlements, 2005, 2013).
Does Intervention Work? Impact and Cost
Ultimately, regardless of whether the exchange rate is thought to be too volatile and misaligned vis-à-vis current fundamentals (e.g., due to the amplifying effects of speculative capital flows) or aligned with volatile fundamentals that are likely to change in the near future, the key prudential macroeconomic question remains: How can macroeconomic policy smooth out excessive exchange rate volatility?
Leaning-against-the-wind exchange rate policies (ERP) are commonly associated with intervention through purchases and sales of foreign exchange whereby the public sector (the central bank or the treasury) takes the opposite side of private investors willing to invest in local currency-denominated assets, to stabilize the clearing price. In the event of capital inflows, intervention by the central bank can take the form of sterilized dollar purchases in the spot market, whereby the central bank “issues” or sells local currency paper in exchange for dollars, changing the supply and demand in the foreign exchange market (i.e., it meets the speculative demand for local assets without altering the money supply), and intervention in the forward market, which has no immediate monetary effect and therefore needs no sterilizing open market operations. But the central bank does not need to be alone in this effort, since a similar effect could be achieved through balance sheet operations by the treasury by issuing local currency debt to cancel or buy back dollar debt or by investing public external or fiscal surpluses (as in the case of sovereign wealth funds) in foreign assets.
Quantifying this effect is not simple, as it entails not only a good account of other factors that may be pressing on both the exchange rate and the level of reserves, but also accurate measures of intervention and currency strength. Moreover, because interventions to depress or prop up the exchange rate are typically triggered at times of appreciation or depreciation, respectively, a casual look at intervention and the exchange rate would tend to yield the “wrong” correlation, which explains the failure of many tests to find any significant effect. The question of whether direct intervention has the expected results has received more attention in recent years, where several studies found a significant yet modest impact of the expected sign (Daude, Levy Yeyati, & Nagengast, 2014 for emerging economies; Blanchard, Adler, & Carvalho, 2015; Fratzscher, Gloede, Menkhoff, Sarno, & Stoh, 2017).
The marginal cost of carrying reserves is proportional to the marginal cost of the debt that implicitly funds them (or, alternatively, that could be cancelled with the reserves), the net of the returns obtained on reserves. Depending on whether the debt issued is in foreign or local currency, this cost is either proportional to the sovereign debt risk premium (the spread paid by a country on its dollar debt in excess of a U.S. Treasury bond of similar duration) (Rodrik, 2006b; Jeanne & Ranciere, 2006), or proportional to the local-to-foreign-currency interest rate differential plus valuations gains or losses (Levy Yeyati, 2008).
These costs have been declining or were never that high to start with. Sovereign risk premiums in developing economies have come down significantly in the 2000s. In addition, reserve carrying costs need to be netted against the benign effect of holding reserves on credit ratings and sovereign spreads (Levy Yeyati, 2008) and could be further reduced by investing reserves in liquid but higher-yielding long-run saving instruments. More importantly, reserves are typically purchased by central banks through interventions sterilized with the sale of local currency-denominated debt, effectively taking the other side of the “carry trade.” Sterilized purchases of foreign exchange are seldom accompanied by higher interest rates because appreciation expectations tend to depress borrowing costs in the local currency. But, to the extent that intervention simply delays the transition to an appreciated exchange rate (hence, the appreciation expectations), it may lead to a valuation loss (i.e., a negative change in the local currency value of international reserves) if the exchange rate eventually appreciates toward a new equilibrium.
It follows that if intervention pursues a mercantilist objective, with appreciation pressures reflecting a more permanent fundamental change, reserve purchases may end up being costly once the exchange rate reaches its new, more appreciated equilibrium. By contrast, if appreciation pressures are a transitory phenomenon due, for example, to cyclical inflows or a transitory run on the currency, the reversion of the exchange rate to its earlier, more depreciated level may eliminate valuation losses and much of the leaning-against-the-wind intervention cost. The fact that equilibrium exchange rates are in practice so difficult to assess—and, as a result, often assumed to be random walks—makes the evaluation of long-term intervention costs rather difficult to pin down ex ante. However, a quick calculation shows that, as many of the recent interventions corresponds to the second kind, the final cost of intervention is rather limited (De la Torre, Levy Yeyati, & Pienknagura, 2013).
A number of lessons can be drawn from the discussion in this article. The first thing to note is that the exchange rate policies (ERP) debate is far from closed. This is a natural consequence of the fact that the pros and cons of alternative ERP (and actual policy choices) evolve both with country characteristics and the global context. Exchange rate anchors that were popular in the developing world in the context of high inertial inflation and partial dollar indexation lost their edge when central banks won the inflation battle and pass-through coefficients declined—coincidentally, at a time when financial integration rendered pegged regimes more vulnerable to self-inflicted crises or self-fulfilling attacks. However, the recent process of external deleveraging and de-dollarization in the developing world, by reducing currency imbalances, increased the scope to use flexible exchange rates as shock absorbers and, by eliminating the need to defend a parity in times of distress, enhanced the scope for countercyclical monetary policy.
The fact that most medium and large developing economies (and virtually all industrial ones) reveal a preference for exchange rate flexibility simply reflects this evolution. However, pegs still represent more than half of the IMF reporting countries—particularly, small ones—indicating that exchange rate anchors are still favored by small open economies that give priority to the trade dividend of stable exchange rates and find the conduct of an autonomous monetary policy too costly, due to lack of human capital, scale, or an important non-tradable sector.
Is the combination of inflation targeting (IT) and countercyclical exchange rate intervention a new IT 2.0 paradigm? While it is still too early to judge, the historical perspective highlights a number of recent developments in the way advanced and emerging economies think of the impossible trinity, which, in a context of deepening financial integration, has become a dilemma between nominal and real stability, for which IT 2.0 represents a workable compromise in the second decade of the 21st century.
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1. Note the similarity with Kose, Prasad, Rogoff, and Wei (2006), where a similar distinction is used to characterize another nominal real connection: financial integration and economic performance.