1

Eduardo Levy YeyatiEduardo Levy Yeyati

The World Bank & Universidad Torcuato Di TellaThe World Bank & Universidad Torcuato Di Tella

December, 2006

Fear of Floating or Fear of Flying:Fear of Floating or Fear of Flying:

Exchange Rate Policy in the New MilleniumExchange Rate Policy in the New Millenium

StoryboardStoryboard

The basics: The debate post-Bretton Woods The tradeoff: Exchange rate regimes and the

real economy The evidence: Regimes in the 2000s The FIT (float + inflation targeting) paradigm:

natural evolution or fad? Fear of flying: building a case for a proactive

exchange rate policy

The basicsThe basics

The real view (‘70s) Trade (and welfare) gains vis à vis users of the

peg currency vs. loss of the exchange rate as a shock absorber in the presence of nominal rigidities.

Pro peg Openness, propensity to trade, trade concentration

Pro float Incidence of real shocks

The basicsThe basics

The political view (‘80s) Bands, “tablitas” & other soft species:

Exchange rate anchors as a “policy crutch” to compensate for the lack of monetary credibility or political power

Pro peg high inflation, weak governments

The basicsThe basics

The financial view (‘90s) The trilemma: as the world integrates,

countries have to choose between monetary autonomy & a stable ER

The bipolar view: Exchange rate policy in emerging economies become more vulnerable to the limits imposed by the trilemma: hard peg or float

The unipolar view: Balance sheet effects due to currency mismatches limit the scope for expansionary devaluations Hard pegs

The tradeoffThe tradeoff

Oversimplifying: Fix vs. flex Enhanced monetary & fiscal discipline

(lower inflation) at the cost of greater sensitivity to real shocks & output volatility…

…except under FD (contractionary devaluations) Is this theoretical tradeoff validated by the evidence?Yes

The tradeoffThe tradeoff

Preliminary evaluation: Pegs contribute to lower inflation

expectations… …at the cost of greater output volatility…

Dep. Var.: Change in growth rate

Flexible Intermediate Peg

[g*j – g t-1, j] 0.926*** (0.039)

0.974*** (0.043)

0.803*** (0.033)

Δtt_pos + Δtt*pos_1 0.059***

[7.99] 0.025 [0.92]

0.091*** [25.30]

Δtt_neg + Δtt_neg_1 0.078** [5.99]

0.138*** [20.42]

0.174*** [64.79]

neg - pos 0.019 [0.24]

0.113*** [6.82]

0.083*** [7.16]

Obs 301 326 714

Regimes & output volatilityRegimes & output volatility

Source: Edwards - LY (2005)

The tradeoffThe tradeoff

Preliminary evaluation: Pegs contribute to lower inflation

expectations… …at the cost of greater output volatility… …and slower growth

Dep. Var.: growth

Period averages

(1974-1999) 5-year averages

(1976-2000)

Peg (%) -1.89** (0.77)

LYS(avg)

-1.13** (0.47)

-1.88*** (0.70)

Obs. 73 73 299

R2 0.522 0.523 0.210

Regimes & growth

Source: LYS (2003)

The tradeoffThe tradeoff

Preliminary evaluation: Pegs contribute to lower inflation

expectations… …at the cost of greater output volatility… …and lower growth Balance sheet effects Subdued inflation fears Volatility

concerns dominate Float Under FD Threshold floats

The bipolar view after Argentina

Argentina: Fiscal (in)disciplineArgentina: Fiscal (in)discipline

0%

2%

4%

6%

8%

10%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

LecopDomestic market, voluntary debtInternational market, voluntary debt

International financial institutionsPrivatizations and other capital income

Source: De la Torre-Schmukler-LY (2002)

Argentina: Monetary (in)disciplineArgentina: Monetary (in)discipline

0

25

50

75

100

125

150

175

200

Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00Real cash in circulation (Left scale)

Real cash and quasi-monies in circulation (Left scale)

Nominal exchange rate (Right scale)

Source: De la Torre-Schmukler-LY (2002)

The bipolar view after ArgentinaThe bipolar view after Argentina

Lack of external discipline by private markets Hard pegs do not lead to fiscal discipline

Fiscal dominance Hard pegs do not lead to monetary discipline Is de jure dollarization hard enough?

Where do we stand?Where do we stand?

Pegs are passé In most cases, inefficient short-term substitute for credibility

Hard pegs failed the test in Argentina Learning to live with BS effects The

(dynamic) scope for countercyclical exchange rate policy The double D: Domestication and de-dollarization of

sovereign debt

A unipolar view in reverse?

• Key criterion: ER variability relative to forex intervention

• The intervention dimension is key to characterized exchange rate policy (as opposed to the evolution of exchange rates) and its consequences

Exchange rate regimes in the 2000s: Exchange rate regimes in the 2000s: Classification

78.23%

8.06%

13.71%

61.29%

19.35% 19.35%

60.74%

14.72%

24.54%

60.63%

16.25%

23.13%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Fix Interm Float

1980 1990 2000 2004

De facto regimes over the years: De facto regimes over the years: DistributionDistribution

Source: LYS (2006)

25.00%

33.33%

41.67%41.67%

33.33%

25.00%

33.33%

16.67%

50.00%

0%

10%

20%

30%

40%

50%

60%

Fix Interm Float

1991 2000 2004

Emerging LATAM: A FIT paradigm?Emerging LATAM: A FIT paradigm?

Source: LYS (2006)

The FIT paradigmThe FIT paradigm

Natural evolution or this year’s model? Less than a paradigm, more than a fad

Negative experience with alternative options Inflation awareness CB autonomy, fiscal

restraint Decline in inflation –and dollar indexation– tilts

the balance towards more flexibility

Inflation targets substitute for ER anchors Still far from the benign neglect

The comeback of exchange rate policy?The comeback of exchange rate policy?

Mercantilist interventions as a substitute for protection Less specific than subsidies Less prone to mismanagement & corruption

Fear of floating or fear of flying? Invertion of the ER anchor problem: sustaining

an undervalued currency Instead of amplified recessions due to price rigidities… …inflationary expansions fueled by positive real

shocks.

Does it work? How?

• Fear of floating’s underlying fears:– Contractionary devaluations (due to BS effects)

and currency and debt crisis propensity– Dollar pricing, pass-through and inflation

• Fear of flying: Leaning against the appreciation wind– Intervention to strenthen the demand for the

foreign currency, to avoid/mitigate appreciation pressures

Fear of flying: A characterizationFear of flying: A characterization

Fear of flying over time (intermediates)Fear of flying over time (intermediates)

Source: LYS (2006)

Fear of flying over time (non-floats)Fear of flying over time (non-floats)

Source: LYS (2006)

……to avoid/mitigate appreciation to avoid/mitigate appreciation pressurespressures

Additional controls: country and time FE, terms of trade, GDP of trade partners, net inflows.

   Variable

Dependent variable: Log Real Exchange Rate

(t)Average (t to t+2)

       

Annual average of int. Index (t)

0.467***0.504***  

  (0.207) (0.216)  

Annual average of int. Index (t-1)   -0.063  

    (0.224)  

Annual average of int. Index (t-2)

 0.163  

    (0.187)  

Annual average of int. Index,

(average over t to t+2)    0.395**

      (0.433)

R-squared 0.993 0.993 0.993Source: LYS (2006)

Real Exchange Rate Plot

Source: LYS (2006)

GNB

BOL

URYMDGBRA

UGA

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ARG

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-1-.

50

.51

e( lt

cr |

X )

-.2 -.1 0 .1 .2e( ind_int_avg | X )

coef = .46681983, (robust) se = .20742027, t = 2.25

Does it work?Does it work?

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2Additional controls: country and time FE, terms of trade shocks, growth of pop., growth of trade

partners, net inflows.

GDPBK

Trend BK Cycle

(t+1) (avg, t+1 to t+3)

Annual average of int. Index (t)

16.207***      

  (3.098)      

∆(foreign_assets/M2) (t) 

3.212***    

    (1.047)    

∆(foreign_assets/M2) (t-3 to

t)   

9.394***

6.652***

5.192***

1.638**

      (2.521) (1.613) (1.265) (0.818)

R-squared 0.287 0.2780 0.285 0.405 0.598 0.111

Source: LYS (2006)

Growth Trend Cycle

Source: LYS (2006)

Does it work?Does it work?-1

0-5

05

10e(

pro

m_d

elta

_gdp

| X

)

-.2 -8.327e-17 .2 .4e( delta_ratio_res_m2_3ant | X )

coef = 6.6519224, (robust) se = 1.613162, t = 4.12

-10

-50

510

e( p

rom

_d_b

ktre

nd_l

gdp_

un |

X )

-.2 -8.327e-17 .2 .4e( delta_ratio_res_m2_3ant | X )

coef = 5.1922213, (robust) se = 1.2649193, t = 4.1

-10

-50

510

e( p

rom

_d_b

kcic

le_l

gdp_

un |

X )

-.2 -8.327e-17 .2 .4e( delta_ratio_res_m2_3ant | X )

coef = 1.6387782, (robust) se = .81826191, t = 2

How?How?

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2. Additional controls: country and time FE, ToT shocks, pop. growth., growth of trade partners,

net inflows.

 ∆ Import ∆ Export

Output Volume Output Volume

(avg. t+1 to t+3)

∆ (foreign_assets/M2) (t-3 to

t)  

17.917***

0.151**14.780**

*-0.012

(3.190) (0.062) (3.142) (0.044)

R-squared 0.9210 0.351 0.920 0.332

Source: LYS (2006)

How?How?

∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2.∆Log(ToT): Change of logarithm of terms of trade.

∆ Gross domestic Savings

∆ Gross domestic Investment

 Variable (t+1 to t+3)

∆(foreign_assets/M2) (t-3 to t) 

8.766*** 10.208***

(2.691) -2.156

R-squared 0.825 0.744

Source: LYS (2006)

Savings & investmentSavings & investment

Source: LYS (2006)

-20

-10

010

20e(

pro

m3_

p_gd

s | X

)

-.2 0 .2 .4e( delta_ratio_res_m2_3ant | X )

coef = 8.7655095, (robust) se = 2.6906957, t = 3.26

-15

-10

-50

510

e( p

rom

3_p_

gkf |

X )

-.2 -8.327e-17 .2 .4e( delta_ratio_res_m2_3ant | X )

coef = 10.229713, (robust) se = 2.1584691, t = 4.74

Taking stockTaking stock

Dedollarization and debt reduction reduce the incidence of capital reversals

Soft FIT paradigm replaces the ER as nominal anchor

Fear of flying is an increasingly popular contender to drive domestic saving & investment (but not so much exports)

The exchange rate debate appears to have gone full circle to the issues of the 1970s

Thank youThank you

33

Eduardo Levy YeyatiEduardo Levy Yeyati

The World Bank & Universidad Di TellaThe World Bank & Universidad Di Tella

December, 2006

Fear of Floating or Fear of Flying:Fear of Floating or Fear of Flying:

Exchange Rate Policy in the New MilleniumExchange Rate Policy in the New Millenium

Balance sheet effects & cBalance sheet effects & crisis risis propensitypropensity

Logit model - Dependent variable: Crisis dummy

er 0.588*** -0.829 -0.610 -2.321 (0.158) (0.706) (1.128) (1.552) FL/FA 0.000*** 0.003** 0.005** 0.007 (0.000) (0.001) (0.002) (0.005) dollar 0.745** 0.674* 0.676 0.411 (0.348) (0.359) (0.416) (0.448) FL/FA * er 0.072** 0.101** 0.146 (0.031) (0.046) (0.095) dollar * er 1.310* 2.027* 3.196** (0.695) (1.049) (1.335) constant -3.555*** -3.493*** -2.455*** -2.912*** (0.292) (0.300) (0.529) (0.496) Observations 1104 1104 535 483 Std. crisis controls Yes Yes Institutions, SS & CC Yes Total effect (F-tests) dollar 5.77** 7.10*** 7.11*** FL/FA 5.27** 4.86** 2.33 er 0.30 3.94* 1.15

Source: LY (2006)

Controlling for deposit dollarization ratios

0%

20%

40%

60%

80%

100%

-2.1

-1.8

-1.4

-1.1

-0.7

-0.3 0.0 0.4 0.8 1.1 1.5 1.9 2.2 2.6 3.0 3.3 3.7 4.1 4.4 4.8 5.2

Exchange rate depreciation

Pro

babi

lity

of

a ba

nkin

g cr

isis

Low dollarization

High dollarization

Balance sheet effects & crisis propensity

Exchange rate volatility (e): average of the

absolute value of monthly changes in the exchange rate

Volatility of exchange rate changes (e ):

standard deviation of monthly changes in the exchange rate

Volatility of reserves (R): average of the absolute

value of monthly changes in international reserves relative to the monetary base of the previous month (both denominated in US dollars)

De facto regimes over the years: De facto regimes over the years: ClassificationClassification

De facto regimes over the years: Classification

Regime e e R

Float Low Low High

Intermediate Med Med Med

Fix High Low Low