Exchange Rate Regime for Emerging Markets

Exchange Rate Regimes for
Emerging Markets

Diploma Paper Submitted to Professor Harris
Dellas, Chair of Applied Macroeconomics,
University of Bern
Winter Semester 05/06

By Kilian Widmer 99-117-806

Exchange Rate Regimes for Emerging Markets Table of Contents

Table of Contents

Figures: ............................................................................................................ III
Tables: ............................................................................................................. III
1. Introduction.................................................................................................... 1
2. Emerging Markets and Exchange Rate Regimes ............................................ 3
3. Fixed versus Flexible ..................................................................................... 5
3.1 The Case for and against Fixed Exchange Rates............................................................7
3.2 The Case for and against Floating Exchange Rates........................................................9
3.2.1. Inflation Targeting ..............................................................................................10
3.3 Lender of Last Resort..................................................................................................12
3.4 Fiscal Policy ...............................................................................................................13
3.4.1. Fiscal Policy as the Problem................................................................................13
3.4.2. Fiscal Policy as an Instrument .............................................................................15
4. The Theory on the Choice of Exchange Rate Regime .................................. 16
4.1. Optimal Currency Area Criteria .................................................................................17
5. Emerging Market Issues ............................................................................... 21
5.1. Credibility..................................................................................................................22
5.2. Access to International Financial Markets ..................................................................24
5.3. Sudden Stops and Currency Crises .........................................................................25
5.4. Trade Issues ...............................................................................................................27
5.5 Effectiveness of Monetary Policy................................................................................28
5.5.1. Monetary Independence ......................................................................................28
5.5.2. Is Expansive Monetary Policy Contractionary? ...................................................31
5.5.3. Pass Through Issues ............................................................................................32
5.5.5. Wage Indexation .................................................................................................33
5.5.6. Unofficial Dollarization ......................................................................................34
5.5.7. Currency Mismatch.............................................................................................36
5.6. Fear of Floating .........................................................................................................41
6. Development of Institutions ......................................................................... 42
6.1. Financial Institutions..................................................................................................42
6.2. Monetary and Fiscal Institutions ................................................................................46
7. Conclusions.................................................................................................. 51

I

Exchange Rate Regimes for Emerging Markets Table of Contents

Annex............................................................................................................... 53
References:....................................................................................................... 60

II

Exchange Rate Regimes for Emerging Markets Figures and Tables

Figures
Figure 1: Emerging Market Economies by Region..................................................................3
Figure 2: Exchange Rate Regimes ..........................................................................................4
Figure 3: Balance Sheets of Currency Boards and Central Banks............................................6
Figure 4: Openness of Fixed Pegs.........................................................................................19
Figure 5: Inflation in Mexico, Chile and Singapore...............................................................30
Figure 6: Development of Debt Securities in Emerging Markets...........................................44
Figure 7: Domestic Debt Securities in Advanced Countries and Emerging Markets………...44
Figure 8: % of Nonperforming Loans in Emerging Markets..................................................45
Figure 9: % of Nonperforming Loans in Advanced Countries and Emerging Markets...........45
Figure 10: Inflation in Emerging Markets .............................................................................47
Figure 11: Public Debt in Emerging Markets ........................................................................49
Figure 12: Emerging Market Sovereign Credit Ratings .........................................................49
Figure 13: Local and Foreign Currency Credit Ratings .........................................................49

Tables
Table 1: Foreign Exchange and Derivatives Markets in Emerging Markets...........................43
Table 2: Inflation, Fiscal Balances, and Seigniorage in Emerging Markets............................48
Table 3: Openness of Emerging Market Economies..............................................................53
Table 4: Domestic Debt Securities in Emerging Markets ......................................................54
Table 5: Domestic Debt Securities in Emerging Markets (in % of GDP)...............................55
Table 6: Domestic Debt Securities in Advanced Countries in 2004.......................................56
Table 7: Public Debt in Emerging Markets ...........................................................................57
Table 8: Percentage of Nonperforming Loans in Emerging Markets .....................................58
Table 9: Percentage of Nonperforming Loans in Advanced Countries...................................58
Table 10: Emerging Market Sovereign Credit Ratings ..........................................................59
Table 11: Fear of Floating (Calvo and Reinhart) ...................................................................60
Table 12: Fear of Floating 2002-2005...................................................................................61

III

Exchange Rate Regimes for Emerging Markets Chapter 1

1. Introduction

The choice of exchange rate regime is a topic that has been thoroughly discussed in
economic literature. Reviewing the literature, I find that the debate has almost raised as many
questions as it has delivered answers. The influence of particular exchange rate regimes on the
real economy essentially remains unclear, as empirical evidence is mixed and problems of
reverse causality arise. Likewise, there is no overall consensus on the relative importance of
specific factors influencing the choice of exchange rate regime. However, one indisputable
conclusion that has emerged is that the standard theory on the choice of exchange rate regimes
for industrialized economies does not apply well to emerging markets and developing
countries.
Emerging markets are a very heterogeneous group of economies that differ widely in their
economic features, especially Asian and Latin American economies. However, one fact all
emerging market regions have in common is that they all faced currency and financial crises
in the past decade, indicating that exchange rate regimes in emerging markets are less stable
than in their industrial counterparts. These crises have shifted the focus of economists on
factors and characteristics that are specific to emerging markets and developing countries, or
are of substantially less importance in advanced countries. Most of these factors are linked to
the lower credibility of monetary policies and institutions in emerging markets, making them
more vulnerable to exchange rate variability.
Essentially, an exchange rate regime should set a framework that enables policymakers to
reach their macroeconomic goals and create an environment that is conducive to economic
growth. In the past both fixed and flexible regimes have not succeeded in providing this
framework, documented in the crises of fixed regimes and the high rates of inflation in
flexible regimes. While exchange rate regimes have an effect in altering the characteristics of
an economy, it is basically a country’s characteristics that determine which exchange rate
regime is best suited to the needs of the respective economy. As the characteristics of an
economy change, so does its “optimal” regime (Frankel, 1999). The vast differences among
emerging markets do not allow a generalization of a best solution concerning the choice of
exchange rate regime. However, there are certain general developments among emerging
markets that speak for an increased amount of exchange rate stability or an increased amount
of flexibility.

1


While both fixed and flexible regimes have their virtues and drawbacks, there is no overall
consensus among economists on which is the better solution for emerging market economies.
In recent years there has been a trend among emerging markets towards increased flexibility,
and currently the majority of economies have floating regimes installed (Hakura, 2005).
However, their actual exchange rate behaviour indicates that many countries are deliberately
limiting swings in their exchange rate, thereby often resembling the behaviour of fixed
regimes (Calvo and Reinhart, 2002).
The focus of this paper is to give an overview of the advantages of fixed and flexible
exchange rate regimes, to document characteristics that are specific to emerging markets, and
to show the implications of these characteristics on the choice of exchange rate regime and the
actual behaviour of exchange rates.
The paper is structured as follows: The second chapter gives an overview of the group of
emerging market economies and different exchange rate regimes. I discuss the basic
theoretical advantages fixed and flexible exchange rate regimes entail in chapter 3, while
chapter 4 takes a look at the standard theory on the choice of exchange rate regime. The fifth
chapter analyses specific factors that are prevalent in most emerging market economies and
how they influence the behaviour of exchange rates and monetary policy. The development of
institutions in emerging markets is the topic of the sixth chapter, while the concluding chapter
touches on the implications of my findings.

2


2. Emerging Markets and Exchange Rate Regimes

Empirical researches in emerging markets analysing the factors that have an influence on the
choice of a specific exchange rate regime, and conversely the influence of certain exchange
rate regimes on real macroeconomic variables, depend on the choice of exchange rate regime
classification as well as the definition of emerging market economies.
There are several different definitions of emerging market economies that differ slightly
from each other, mainly in the number of economies included, but essentially all definitions
are grouped around the same core of economies. I will be using the group of 25 emerging
market economies (Figure 1) presented in Rogoff et al. (2003), which are identical to the
group of economies in the Morgan Stanley Capital International (MSCI) index.

Figure 1: Emerging Market Economies by Region
Latin America
Argentina Brazil Chile Colombia Mexico Peru
Venezuela
Asia
China India Indonesia Korea Malaysia Pakistan
Philippines Thailand
Europe, Middle East, and Africa (EMEA)
Czech Republic Egypt Hungary Israel Jordan Morocco
Poland Russia South Africa Turkey
source: Rogoff et al. (2003)

Regarding the classification of exchange rate regimes, there seems to be no consensus
among economists on a single, correct classification scheme. A problem that arises is that the
behaviour of exchange rates (de facto) often does not correspond with the announced regime
(de jure) in place. While exchange rate classifications in the past were based on the
announced regime, recent classifications have focused on the actual behaviour of regimes1.
Other principal differences among exchange rate classifications arise due to the different
number of individual regimes within classifications and the usage of different methodologies,
with some economists also considering the behaviour of, among others, parallel exchange
rates, interest rates, and the level of reserves. Frankel (2003) shows that the correlations
among different de facto regime classifications are not very high.

1
See, for example, Reinhart and Rogoff (2004).

3


Figure 2: Exchange Rate Regimes
a
Exchange Rate Regimes (de facto)

Dollarization and monetary union
Currency board
Fixed peg China* Jordan* Malaysia Venezuela Morocco
Peg within bands Hungary*+
Crawling peg
Crawling bands
Managed floating Argentina Czech Rep.+ Egypt India Indonesia
Pakistan Peru+ Russia Thailand+
Independently floating Brazil+ Chile+ Colombia+ Israel*+ Korea+
Mexico+ Philippines+ Poland+ South Turkey
Africa+
a. As of December 31, 2004.
* The regime operating de facto in the country is different from its de jure regime.
+ Monetary policy of inflation targeting.
source: IMF

The exchange rate regime classification of the IMF (Figure 2) consists of 8 different
regimes. The regimes are ordered by the rigidness of their exchange rate. The regimes at the
top display the least amount of exchange rate variability, while descending in the order of
regimes is associated with a gain of exchange rate flexibility. Exchange rate regimes are often
grouped into three general categories of regimes: fixed, intermediate, and floating. Hard pegs,
i.e. dollarized economies, monetary unions and currency boards, belong to the fixed category.
Pegs within bands, crawling pegs, and crawling bands are considered intermediate regimes, while
managed and free floats would make up the floating category. Assigning fixed pegs to a group is
the most difficult task, as they could be assigned to either the fixed or intermediate category.
Reviewing the classification of the emerging markets, it is obvious that the majority have
decided for floating regimes, while at the other end, no hard pegs are in place (anymore).
However, empirical evidence indicates that emerging markets float in a different way than
advanced countries by trying to limit their exchange rate swings, thereby often resembling the
behaviour of less flexible regimes2.
In the following, I will not refer to specific exchange rate regimes, but rather discuss the
advantages of fixed and flexible regimes as well as conditions and developments favoring fixed or
flexible exchange rates and/or increased stability or flexibility.

2
See Calvo and Reinhart (2002) and Hausmann et al. (2000).

4


3. Fixed versus Flexible

One of the principle insights of the Mundell-Fleming model3, and macroeconomic theory in
general, is the hypothesis of the impossible trinity: a country cannot simultaneously have a
fixed exchange rate, unrestricted capital mobility, and an independent monetary policy. It
must choose two out of three. Given that the choice of capital controls is rarely chosen, the
choice effectively boils down to a trade-off between exchange rate stability and flexibility
provided by an independent monetary and exchange rate policy. However, as Frankel (1999)
notes, the implications of the impossible trinity do not compel an economy to choose between
stability and flexibility per se. Rather an economy is free to opt for an in-between
(intermediate) solution, for example by limiting the magnitude of exchange rate swings or
defending an exchange rate peg only to the extent that it does not interfere with other
macroeconomic objectives. The advantages of stability decrease with the amount of flexibility
a regime exhibits, while in turn the advantages of flexibility decrease with the rigidity of the
exchange rate. Unless otherwise noted, I will be assuming high capital mobility without
capital controls throughout my paper.
Absolutely fixed exchange rate regimes or hard pegs, i.e. currency unions, unilateral
currency unions (dollarization), and to a certain extent currency boards (depending on their
reserve requirements) guarantee a fixed exchange rate through the adoption or creation of a
foreign currency as legal tender, or in the case of currency boards through a conversion rate
that is fixed by law. An exit from the regime and the exchange rate parity is associated with
large economic costs and political difficulties, so that the public views a (voluntary) departure
as highly unlikely (Ghosh et al., 2002). Hard pegs are based on a simple monetary policy rule:
changes in the monetary base are determined by the balance of payments account
(Williamson, 1995, Schuler, 2000). A deficit contracts the money supply, while a surplus
enlarges it. Adopting a hard peg means that an economy loses its ability to create money
(monetary unions) or it is severely constrained (currency boards) and that domestic interest
rates are tied to the rates in the anchor country through interest rate parity. Thus, an economy
must sacrifice its monetary sovereignty and accept the monetary policy of the country it
pegged its currency to in order to fix its exchange rate.

3
Mundell (1963) and Fleming (1962)

5


Figure 3: Balance Sheets of Currency Boards and Central Banks

Currency board Central Bank
Assets Liabilities Assets Liabilities
Foreign reserves Cash Foreign reserves Cash
Net worth Domestic assets/credit Deposits of
source: Williamson (government debt) noncommercial banks
(1995) Net worth
source: Williamson
(1995)

Intermediate regimes provide a solution for economies that are unwilling to totally give up
on an independent monetary policy but are equally unwilling to face large exchange rate
swings. As mentioned above an economy can choose the degree of flexibility/stability best
suited to its needs. In this context a regime that is/was often chosen is a fixed but adjustable
exchange rate regime (FBAR). In contrast to hard pegs, where the monetary authority only
has foreign reserves at its disposal, or no reserves at all in the case of dollarization, under a
FBAR the central bank has a foreign and a domestic component to its reserves (Figure 3),
which allows the central bank to manage the exchange rate. When the fixed exchange rate
comes under pressure of depreciating (appreciating), the central bank can sell (buy) foreign
reserves to support the exchange rate. However, the ability to defend the exchange rate is
limited to the amount of foreign reserves an economy possesses. In the case of strong market
pressures or fundamental macroeconomic disequilibria, FBARs have an escape clause
allowing them to adjust the exchange rate (Ghosh et al., 2002). This option, however, should
only be chosen in emergency cases, as frequent exchange rate readjustments undermine the
credibility of the exchange rate peg (Corden, 2002).
Under a purely floating exchange rate the domestic monetary authority is indifferent to
changes of the exchange rate. Having no preference for a particular exchange rate, there is no
need for the central bank to intervene in the foreign exchange market and, hence, there is
theoretically no need for a large stock of foreign reserves (Ghosh et al., 2002). However, as
many economists note, pure floaters exist only in economic theory. Thus, even under floating
exchange rate regimes monetary policy is diverted to some extent to limit excessive exchange
rate fluctuations. However, there is no particular commitment to a certain exchange rate and
therefore the exchange rate is much less of a constraint to monetary policy than under other
regimes.

6


3.1 The Case for and against Fixed Exchange Rates

In the ensuing brief discussion of the advantages and the drawbacks of exchange rate
regimes, I will focus on the polar extremes of absolutely fixed and purely floating exchange
rates.
One of the biggest advantages of fixed exchange rate regimes is their alleged ability to fight
inflation. Fixing the exchange rate has been a way of quickly reducing inflation in countries with
high inflation and a chronic inflation problem, such as Ecuador and Argentina. Several empirical
studies have shown that (high) inflation is costly and impairs the economic growth of an economy.
Adopting an ultimately fixed exchange rate regime provides a credible nominal anchor for
monetary policy. By doing so, an economy imports the monetary policy of the country it pegged its
currency to as well as its credible commitment to price stability. As a corollary, inflation
expectations are lowered to a level that is comparable with the anchor economy (Mishkin, 1999).
The monetary rules of a hard peg preclude the conduct of an independent monetary policy, and
consequently an inflationary policy as well as the monetization of fiscal deficits. Thus, by fixing
the exchange rate to a low inflation, hard currency country an economy eliminates discretion,
establishes monetary discipline, and ultimately will lower inflation expectations (Corden, 2002).
Additionally a fixed exchange rate is a transparent and simple nominal anchor in comparison with
other possibilities. It can be easily observed and verified by the public and thus will help to reduce
uncertainty, which ultimately enhances the credibility towards price stability (Frankel, 2003).
A further argument of advocates of fixed exchange rates is that fixed exchange rate regimes have
a positive effect on trade. Short and middle-term exchange rate volatility often cannot be
explained by economic fundamentals, with excessive volatility posing a threat for the trade sector
of an economy (Corden, 2002). Hard pegs guarantee a fixed exchange rate, and thus minimize the
exchange rate risk. As a result, transaction costs will fall and trade will be promoted as well as
investment. In general, the harder the peg, and thus the less frequent exchange rate adjustments
are, the greater the gains from trade will be. Naturally currency unions will create the greatest
benefits, due to the elimination of the exchange rate and transaction costs. In a study that has
received much attention due to its astonishing results, Frankel and Rose (2002), using data for
more than 180 countries from 1970 to 1995, find that a common currency triples trade with close
trading partners. They also find that enhanced trade will lead to closer economic and financial
integration, especially with the anchor country, promote openness to trade and ultimately lead to
higher economic growth. Using a meta-analysis to examine the effect of currency unions on trade
from thirty-four empirical studies, Rose (2004) finds a smaller effect of currency unions on trade

7


than previously, ranging from over 30% up to 90%, but the results nonetheless indicate a strong
positive relationship between currency unions and trade. While empirical evidence suggests that
currency unions enhance trade, the (negative) link between exchange rate volatility and trade is
less clear-cut. A number of studies find no statistically significant relationship4 and in the cases
where studies do find a relationship, the effect is relatively small, with the consensus estimate
being that the total elimination of exchange rate volatility would lead to a roughly 10% increase of
trade in industrialized countries (U.K. Treasury, 2003). However, it does seem sensible that
countries with intensive trade ties or countries wishing to intensify their trade ties would favour a
fixed exchange rate.
A third advantage often mentioned in economic literature is that hard pegs will lower real
interest rates (Berg and Borensztein, 2000). By fixing the exchange rate the expected likelihood of
depreciations is reduced and with it the currency risk component of domestic interest rates. Lower
interest rates together with lower inflation would promote investment, lead to an expansion and
deepening of the financial sector and would also reduce debt-servicing costs of the government.
With the currency risk component depending on the likelihood of a future devaluation, here too
the general rule of the harder the peg the greater the benefit applies. Advocates of fixed exchange
rates cite the example of Panama, a dollarized economy, where the nominal interest rates and
interest rate spreads have been persistently lower than in most other Latin American countries,
while real interest rates have been low and steady (Schuler, 2000).

The inability to pursue an independent monetary policy is the principal drawback of fixed
exchange rate regimes, as its makes them vulnerable to negative shocks.5 Under fixed exchange
rates and complete capital mobility, expansionary monetary policy has no effect on the economy.
The additional liquidity created leaves the economy via a balance of payments deficit. In the case
of a real negative shock, which will require an adjustment of the real exchange rate, the effects of
an economic downturn cannot be corrected by a depreciation of the currency. As a consequence
the downward adjustment must be borne by wages and prices, which inevitably leads to a higher
and longer economic contraction than under a flexible exchange rate regime (Frankel, 1999).
Furthermore, the imported monetary policy can be the source of disturbance in the form of an
asymmetric shock. If the fixed country and the anchor country are at quite different positions in
their business cycles, then the fixed economy could face an increase of interest rates although a
decline would be required (Goldstein, 2002). In addition, the common monetary policy has the

4
See, for example, Clark et al. (2004)
5
Based on the realistic assumption that nominal wages and prices are sluggish and somewhat inflexible
downwards. In the case of a positive shock the outcome does not depend on the exchange rate regime (Corden
(2002).

8


effect that the fixed economy cannot insulate itself from shocks to the anchor economy (Mishkin,
1999).
A second disadvantage is the danger of the fixed exchange rate becoming misaligned and the
difficulties associated with restoring an exchange rate that corresponds to the economic
fundamentals (Calvo and Mishkin, 2003). Recent experiences of countries adopting a hard peg,
among others Ecuador, Argentina and Estonia, show that they experienced significant real
appreciation in the first years of implementation, due to higher inflation than in the anchor
economy6. A correction of the real exchange rate would call for a decline in nominal prices and
wages or a lower rate of inflation than in the anchor economy, both of which, if feasible at all,
would put a strain on economic growth. Thus, misalignment problems are more of a concern for
countries with low flexibility in wages and prices. An additional problem is those large exchange
rate misalignments will inevitably increase the chances of a speculative attack (Ghosh et al.,
2002). Using taxes and imports could function as a substitute for wages and prices to achieve
adjustment of the real exchange rate. However, fiscal institutions in most emerging markets are
probably not up to the task (Calvo and Mishkin, 2003).
An issue that concerns hard pegs to a lesser extent but merits consideration nonetheless is the
susceptibility of fixed regimes with a less credible commitment to a fixed exchange rate, i.e.
intermediate regimes, to speculative attacks on their domestic currency, as episodes in the last
decade have shown (Mishkin, 1999, Corden, 2002). A speculative attack challenges a country’s
commitment to the fixed exchange rate. A country can defend its exchange rate by selling foreign
exchange out of its reserves or by raising the interest rate. However, foreign reserves are limited
and raising interest rates has adverse effects on the economy and especially on the banking sector,
so that an economy might see itself forced to devalue its currency. Empirical evidence indicates
that in emerging market economies rigid regimes have had a higher incidence of banking and
currency crises (Rogoff et al., 2003).

3.2 The Case for and against Floating Exchange Rates

The main advantage of floating exchange rate regimes is the principal drawback of fixed
regimes, namely the ability to pursue an independent monetary policy suited to the needs of the
domestic economy. In contrast to fixed regimes, interest rates can be set independently, at least in
theory. Furthermore, flexible exchange rates provide better insulation from negative external and
real shocks, due to the fact that the nominal exchange rate is quicker to respond than domestic

6
See Ghosh, Gulde and Wolf (1998, 2002) and Lopez (2002).

9


prices and wages, for any given shock (Corden, 2002). Exchange rate flexibility allows an
economy to respond to a negative external/real shock by increasing the monetary base, leading to
a depreciation of the domestic currency, which will provide a stimulus for the domestic economy.
While these measures probably will not be able to avoid a recession, it would be shorter and less
pronounced than under fixed exchange rates (Frankel, 1999).
A second similar advantage is that even when the economy does not pursue a discretionary
policy, floating exchange rates provide an automatic stabilizer for an economy against shocks
affecting the terms of trade (Frankel, 2003). If the international demand for a country’s products
falls, so will its currency. In turn, a depreciated currency will help compensate for the fall in
international demand.

Floating regimes often entail large exchange rate swings, which cause the exchange rate risk and
transaction costs to rise, and thereby discourage trade and investment. But, as Corden (2002)
explains, smoothing the exchange rate is not always the proper decision. If excessive exchange
rate volatility is caused by changes and developments of the economic fundamentals than
exchange rate swings are “justified” and should be tolerated. However, if changing market
expectations and herd behaviour by investors/speculators rather than economic fundamentals are
the cause for volatility in the exchange rate, which would appear to be the majority of cases, than
by adopting a regime of fixed exchange rates one would alter market expectations and thus would
increase the stability of the system. In contrast, a flexible exchange rates regime would merely
translate exchange rate volatility into interest rate volatility, which would not be a significant
improvement from a macroeconomic point of view (Corden, 2002).
Fixed exchange rate regimes seem to have a slight edge against flexible regimes regarding price
stability. In regimes with flexible rates the exchange rate cannot serve as a nominal anchor.
Instead the most popular (and successful) choice is to define an inflation target as the nominal
anchor. In contrast to hard pegs, under inflation targeting the possibilities of an inflationary
monetary policy and monetization of fiscal deficits cannot be totally ruled out, which is a
disadvantage, especially in many emerging market economies with their histories of monetary and
fiscal mismanagement. An additional factor speaking for exchange rate pegs is that they are
somewhat easier to monitor and verify than inflation targets (Corden, 2002).

3.2.1. Inflation Targeting

Adopting a flexible exchange rate regime narrows the choice of possible nominal anchors
for monetary policy. To be more precise, there are basically two possibilities: a monetary

10


target or an inflation target. Among emerging markets the latter has gained popularity and is
to date associated with 13 countries (Figure 2), notably all freely floating regimes except for
Turkey.
Mishkin (2000, p.1) defines the 5 main elements of an inflation targeting monetary policy
strategy as follows: “1) The public announcement of medium-term numerical targets for
inflation; 2) an institutional commitment to price stability as the primary goal of monetary
policy, to which other goals are subordinated; 3) an information inclusive strategy in which
many variables, and not just monetary aggregates or the exchange rate, are used for deciding
the setting of policy instruments; 4) increased transparency of the monetary policy strategy
through communication with the public and the markets about the plans, objectives, and
decisions of the monetary authorities; and 5) increased accountability of the central bank for
attaining its inflation objectives.”
The main issue of monetary policy under floating exchange rates is the commitment to price
stability. Under inflation targeting, the monetary authority seeks to achieve the predefined level of
inflation by varying the short-term interest rates. A specific feature of inflation targeting that helps
to achieve price stability is its simplicity and observability. Assisted by a good communication
policy, monetary policy becomes comprehensible and transparent for a broad public, as they can
easily track the monetary authority’s success. However, for the commitment to price stability to
be successful an independent central bank is necessary, which is not constrained by fiscal or
government considerations and is autonomously in charge of monetary policy instruments
(Masson et al., 1997). While price stability is the overriding policy objective, inflation
targeting allows enough discretion to deal with other objectives, such as limiting excessive
exchange rate swings and reducing output volatility (Mishkin, 2004). Inflation targeting
undoubtedly has its virtues, but it also has its drawbacks. A problem in the conduct of inflation
targeting is that inflation is not easily controlled by the central bank. Moreover, economies
starting from a high level of inflation will experience much more difficulties lowering and
subsequently stabilizing inflation, suggesting that inflation targeting should be implemented after
some successful disinflation (Masson et al., 1997). A second difficulty arises due to the varying
time lags from the adjustment of the interest rate to the subsequent effect it has on the inflation
rate (Corden, 2002). Thus, short-term variations from the target can occur even in the case of
proper policy implementation. In the long-term though, short-term variations (caused by time
lags) alone should not endanger a well-conducted inflation targeting policy.
Skeptics, such as Masson et al. (1997), doubt that some emerging markets have the ability and
willingness to conduct a successful inflation targeting policy. Masson et al. (1997) see the
relatively high income from seigniorage as a manifestation of fiscal dominance and, hence,

11


lacking independence of central banks. Moreover, the authors argue that there seems to be no
consensus that low inflation should be the overriding objective of monetary policy in many
developing countries and emerging markets. High initial rates of inflation and fragile financial
systems are viewed as a serious impediment to a successful implementation and conduct of
inflation targeting. However, the authors also find that a strengthening of institutions may turn
inflation targeting into an attractive option for some developing countries and emerging markets
in the future.

3.3 Lender of Last Resort

Among economists there seems to be no overall consensus on whether the lacking lender of last
resort (LOLR) capability of fixed exchange rate regimes is actually an advantage or a
disadvantage. As is generally known, hard peg regimes cannot independently set their money
supply. This facts turns out to be a double-edged sword. While this helps in preventing inflation, it
may be harmful for financial stability, since extended domestic credit cannot be provided in times
of crisis. In this context, Larrain and Velasco (2001, p32) suggest: “The price of low inflation may
be endemic financial instability.”
Proponents of flexible regimes stress the importance of bail-outs in the case of bank runs and
financial turmoil, in order to prevent a full-fledged financial crisis from happening. Moreover,
they believe that the loss of LOLR function may increase financial instability by augmenting the
probability of a banking crisis in countries with weak institutions (Volbert and Loef, 2002).
On the other hand, advocates of fixed regimes believe that the importance of the lender of last
resort function under flexible exchange rates is overestimated (Calvo and Mishkin, 2003, Lopez,
2002). They doubt that emerging market central banks can perform the LOLR ability as well as
their counterparts in industrialized economies for 2 main reasons. The first is that most emerging
markets do not have sufficient foreign reserves (Salvatore, 2002), and more importantly second,
most monetary institutions lack the required credibility to be an efficient lender of last resort. In
an industrialized country the central bank can issue excess liquidity and inject it into the frail
banking system. Due to the credibility of the central bank, the additional money supply is believed
to be temporary and will be withdrawn when the time is ripe. In contrast, in developing countries
with past inflation problems the liquidity infusion is not believed to be temporary, which in turn
raises inflation and depreciation expectations, ultimately exacerbating, rather than easing, the
already critical situation (Mishkin, 1999).
Another line of thought is that by depriving the central bank of its LOLR ability, fixed exchange
rate regimes can avoid or at lest reduce moral hazard problems such as excessive risk taking by
the banks (Lopez, 2002). As a result, the chances that a situation of financial turmoil arises

12


decline, thereby lessening the need for a LOLR altogether. In case that a financial crisis does
arise, the LOLR ability could be performed by commercial banks. Advocates of hard pegs
contend that they will lead to higher financial integration and consequently result in a higher
number of international banks. Their argument is that in the event of a bank run, it is assumable
that foreign banks would bail out their local branches (Larrain and Velasco, 2001). However,
if this is sufficient to stabilize the financial sector is arguable.
Contingent credit lines, rigorous reserve requirements for domestic commercial banks, and
international borrowing are the other main possibilities for economies with fixed exchange rates
to deal with situations of financial instability. But compared with the possibility of money
creation, these alternatives appear to be inferior due to the different drawbacks each entail, such as
higher costs, questionable availability, possibly insufficient amounts of credit, and time lags
(Goldstein, 2002).
Ultimately, it seems that the ability to conduct an effective lender of last resort function under
flexible exchange rates depends on the credibility and the quality of the involved institutions
(Calvo and Mishkin, 2003). Thus, only if emerging market central banks have the required
credibility can the LOLR function be an advantage for flexible regimes.

3.4 Fiscal Policy

In the context of exchange rate regimes fiscal policy can take more than one role. While fiscal
policy can be used as a government instrument to stabilize the economy, it can also be a source of
disturbance when the fiscal budget gets out of hand.

3.4.1. Fiscal Policy as the Problem

A recurring reason for exchange rate and financial instability among emerging markets in the
past, especially in Latin America, has been the prevalence of fiscal dominance, where “the fiscal
deficit determines the money growth rate, and the money growth rate determines the rate of
inflation of domestic wages and prices” (Corden, 2002, p.109). A thing that fixed exchange rate
regimes and flexible regimes under inflation targeting have in common is that both regimes are
not sustainable with large fiscal deficits (Mishkin, 2000). However, unsound fiscal policies pose a
bigger threat to fixed regimes. While under flexible regimes the inflation target cannot be
achieved, thereby nagging on the credibility of monetary institutions, the exchange rate at least
provides a certain amount of flexibility to deal with the situation. Whereas under fixed exchange
rates, large fiscal deficits jeopardize the viability of the peg. Continuous high fiscal deficits will
lead ceteris paribus to a deterioration of the current account balance, which will steadily increase
the borrowing costs for the domestic economy or force it to monetize its deficits (Corden, 2002).

13


In order to correct the situation the fixed exchange rate must be given up and a more flexible
regime must be installed to reduce the fiscal deficit.
Conventional wisdom has it that fixed exchange rates are better suited to generate fiscal
discipline. Under hard pegs the possibility of monetization of fiscal deficits is ruled out. Instead
foreign reserves must be used to compensate a fiscal deficit. Foreign reserves are limited, and a
lower level could jeopardize the sustainability of the fixed exchange rate. A collapse of the peg
would entail large economic and political costs and surely put an end to the reign of the
policymakers in charge. Thus, one would assume that policymakers, for their own sake, take a
prudent approach to fiscal expenditure (Larrain and Velasco, 2001). However, funding of fiscal
deficits must not affect foreign reserves. Deficits also can be financed through government
issuance of public bonds. Thus, a hard exchange rate peg does not rule out the possibility of a
large fiscal deficit. The example of Argentina, which ultimately defaulted on its debt, proves
evidence that hard pegs are by far not a guarantee for solid fiscal policies (Calvo and Mishkin,
2003).
According to proponents of flexible rates “the combination of a flexible exchange rate and
capital mobility provides the most effective form of discipline” (Corden 2002, p.113). Tornell
and Velasco (2000) argue that key difference between fixed and flexible regime is in the
intertemporal distribution of the costs of imprudent fiscal behaviour. In contrast to fixed
exchange rate regimes, lax fiscal policies under flexible regimes have an immediate impact on
the economy by altering the exchange rate and the price level. These costs must be taken into
consideration by the policymakers in charge, giving them an incentive to balance the budget.
Alternatively under fixed rates, lax fiscal policies affect the level of debt and/or foreign
reserves, which effectively hide the costs from the public and push them into the future. It is
only when the amount of debt or reserves reaches a critical level, which questions the
sustainability of the peg, that the effective costs are borne. Thus, considering the relative short
average duration of pegs, as well as the political instability in many emerging market
economies, the effective costs of fiscal profligacy under fixed exchange rates might have to borne
by the next generation of policymakers, thereby providing little incentive for fiscal discipline for
the present generation.
The empirical evidence regarding the effect of exchange rate regimes on fiscal discipline is
mixed.7 However, reviewing the empirical results, which point in both directions, the
conclusions drawn by the IMF (2001, p143) seem to be the most instructive from my point of
view. “History points to episodes of significant loosening of fiscal policies under currency

7
See, for example, Tornell and Velasco (2000) for a “flexible point of view” or Ghosh, Gulde, and Wolf (1998)
for a “fixed point of view”.

14


boards, central bank independence, and partial and even full dollarization; moreover,
significant reductions in fiscal deficits in several countries that adopted inflation targeting in
recent years are yet to be seen. This suggests that monetary (exchange rate) arrangements per
se have only limited power to fix “real” problems arising from a fiscal regime inconsistent
with the goal of price stability.”

3.4.2. Fiscal Policy as an Instrument

While fixed exchange rate regimes do not possess the ability to use monetary policy as an
instrument for macroeconomic purposes, they are still left with an instrument at their disposal,
namely fiscal policy. A successful active fiscal policy provides fixed exchange rate regimes with
an instrument to deal with negative shocks and resulting economic downturns, thereby moderating
their principal weakness (Corden, 2002).
However, fiscal policy is not a replacement for monetary policy. The main distinction between
the 2 policies is that: “Fiscal policy is financing while exchange rate depreciation is adjustment”
(Corden, 2002, p.98). A successful fiscal policy used as an instrument to stabilize the economy
requires the government budget to be balanced in the long-term, otherwise the fiscal deficit will
become a burden to the economy. This means that increases in public spending will eventually
have to be reversed and, hence, can only be a temporary stimulus to the economy. Thus, fiscal
measures do not lead to a new equilibrium as in the case of monetary/exchange rate policy, but
they can provide temporary relief from negative shocks (Corden, 2002).
There are a number of difficulties that arise when trying to use fiscal policy as a countercyclical
instrument in fixed exchange rate regimes. First, assuming that fiscal policy is primarily
implemented countercyclical, an economy choosing to expand fiscal expenditures must be able to
acquire fiscal surpluses in times of economic prosperity in order to budget its balance. However,
as only few emerging market economies have been able to record fiscal surpluses in recent years
(table 2) the option of fiscal expansion should be regarded with caution (Corden, 2002). Second,
emerging market economies with high initial levels of public debt (table 7) will probably be not
willing to deliberately expand public spending. The disadvantages, such as an increase of the
borrowing costs, and concerns over inflationary finance as well as the sustainability of the
exchange rate peg, could weigh too heavy (Goldstein, 2002). Third, even if an economy can
produce fiscal surpluses and has a strong debt position, the implementation of an anticyclical
fiscal policy might fail due to the reluctance of politicians. In an economic downturn most
politicians tend to lower fiscal expenditure, convincing them to do the opposite will surely not be
accepted unanimously (Corden, 2002).

15


Countercylical fiscal policy can temporarily weaken the effects of a recession, which would
speak in favour of fixed exchange rates. But the conditions for a successful implementation do not
seem to coincide with the characteristics of most emerging market economies, implicating that
most emerging markets are not able to deliberately use fiscal policy as an instrument.

4. The Theory on the Choice of Exchange Rate Regime

After giving a brief overview on the principal advantages and drawbacks of fixed and
flexible regimes, in this section I focus on country characteristics that favour either flexibility
or stability. In the following discussion of specific criteria and characteristics, conclusions that
are drawn will be based solely on the particular characteristic in focus. Unless otherwise noted, I
will always be assuming that other factors will remain equal.
When forming a decision on the choice of an exchange rate regime it is necessary to view the
whole picture and not to focus on particular country characteristics. A country’s characteristics
primarily dictate if the advantages of a fixed or a floating regime will prevail. In every country
there will be certain factors that speak for and against the adoption of a certain exchange rate
regime, and not everywhere will the same factors be of equal importance. Thus, in the debate on
the choice of exchange rate regime one size does not fit all (Calvo and Mishkin, 2003).
Furthermore, policymakers should be aware that country characteristics are subject to changes
over time, so that the ideal regime for today need not be the ideal regime for tomorrow (Frankel
1999). Additionally, countries should verify their ability to adopt a particular regime, notably the
implementation of a hard peg, i.e. dollarization or a currency board, requires a high stock of
foreign reserves (Goldstein, 2002). Last but not least, besides all the economic, political, and
geographical criteria involved in such a decision, one should not forget to consider the possibly
most important factor of all, namely the public’s will. Even the “optimal” exchange rate regime is
doomed to fail if it does not have the public’s backing and approval.
Economic literature states a vast number of criteria that influence the choice of exchange rate
regime. A traditional criterion that is usually mentioned first in the debate of fixed-versus-floating
is the nature of shocks. According to the Mundell-Fleming framework an economy that
predominantly encounters domestic nominal disturbances is better off adopting some sort of fixed
regime. The rigid nominal exchange rate prevents monetary shocks from having real
consequences. On the contrary, if real and/or external shocks are the main cause of concern for an
economy, then a floating regime seems to be the better choice. The required change in relative

16


prices can be achieved more rapidly by adjusting the nominal exchange rate, thereby limiting the
negative effects on the real economy.
Thus, following the Mundell-Fleming approach, one would expect to see countries, which are
subject to large real shocks to have some sort of flexible regime in place. Furthermore, the
observed increase of capital mobility in recent years (IMF, 2005a) can be viewed as an indicator
that the significance of real shocks is growing. But, contrary to economic theory empirical
evidence is less clear-cut. Hausmann et al. (1999) refer to a number of studies that find that
increased terms of trade variability is associated with a higher probability of adopting a fixed
exchange rate. They see the reason for this behaviour in the deeper financial markets that fixed
exchange rate regimes allegedly provide.8 On the other hand, findings by Broda (2003, 2004) and
Edwards and Levy-Yeyati (2003) support the conventional view that negative real shocks have a
larger impact on the output of fixed exchange rate regimes.9 Additionally the authors show the
presence of asymmetries in price behaviour (downward nominal inflexibility), slower real
exchange adjustment under pegs, and that terms-of-trade disturbances account for a higher extent
of real GDP fluctuations in developing countries under pegs (33%) than under floats (15%).

4.1. Optimal Currency Area Criteria

A further traditional approach that takes many relevant country characteristics into account is the
theory of Optimal Currency Areas (OCA) developed by Mundell (1961) and McKinnon (1963).
The OCA theory focuses on a country’s geographical and trade features and provides a framework
to evaluate which countries/regions are best suited to share a common currency and a common
monetary policy. Frankel (1999, p.14) defines an OCA as “a region that is neither so small and
open that it would be better off pegging its currency to a neighbor, nor so large that it would be
better off splitting into subregions with different currencies.” At the heart of the OCA approach is
the insight that the benefits of a fixed exchange rate increase the more 2 countries trade with each
other. The principal reason speaking against the realization of an OCA is its vulnerability to
asymmetric shocks. But even in the presence of asymmetric shocks there are factors that can
mitigate their adverse effects, so that it might still be beneficial for an economy to adopt a fixed
exchange rate. In the following, I will give an overview of the OCA criteria and how they
influence the choice of exchange rate regime.

8
Hausmann et al. (1999, p8) argue that: „fixed exchange rate regimes should result in deeper financial markets,
which should be particularly important in economies facing important terms of trade shocks.”
9
Broda (2004) focusing on developing countries, finds that a 10% fall in the terms of trade reduces real GDP by
1.9% in pegs and by 0.2% in floats, while Edwards and Levy-Yeyati studying a sample of 183 countries find a
real GDP reduction of 0.4% for floats and 0.8% for pegs.

17


Openness and size: A crucial role in the choice of regime plays the degree of openness to trade,
which can be interpreted as a measure of economic integration (Frankel, 2003), a country exhibits.
There are principally three ways that openness directly affects the choice of exchange rate regime.
First, the higher the degree of income that an economy earns through trade, the larger will be the
adverse effects resulting from exchange rate variability (Corden, 2002). Thus, open countries
seeking to stabilize their output should adopt some form of fixed exchange rate regime. Second,
since international trade between developing and developed countries is principally invoiced in
the stronger currency (McKinnon, 1999, Goldberg and Tille, 2004), nominal wages and prices in a
very open economy are likely to be denominated in a foreign currency or to be linked to the
exchange rate (Corden, 2002). Currency substitution and/or indexation impede the effectiveness
of a discretionary monetary policy and thereby strengthen the case for fixed exchange rates10.
Third, the more open an economy is, the less it needs a flexible exchange rate as a shock absorber
(Corden, 2002). An open economy will display a high marginal propensity to imports. In the case
of a fall of demand resulting form a negative shock, the higher the marginal propensity to imports
is, the smaller the effect on domestic nontradables will be, and thus, the lower the resulting
unemployment. Thus, based solely on the OCA criterion of openness, the advantages of fixed
exchange rates seem to overweigh and consequently a fixed regime would seem to be the superior
choice for an economy with a large trade sector.
Indeed, the fixed pegs among the 25 emerging market economies display a higher degree of
average openness11 than the rest (table 3 and figure 4). However, Morocco and Venezuela do not
exhibit a high degree of openness, while the significantly more open economies of the Philippines
and Thailand have floating regimes in place, indicating that there are factors other than openness
influencing the choice of exchange rate regime.

10
I will discuss the effect of indexation and currency substitution on monetary policy in more detail further below.
11
Measured as the average of exports and imports in percent of GDP.

18


Figure 4: Openness of Fixed Pegs

Openness of Fixed Pegs 2004 (in % of GDP)
120

100

80

60

40

20

0
1
Malaysia Jordan China Morocco Venezuela average of other EMs
Source: World Bank, World Development Indicators

Another way openness indirectly influences the choice of exchange rate regime is through the
size of an economy. Extremely open economies are likely to be very small economies and small
economies tend to be more open than larger economies (Corden, 2002). Additionally, the benefits
of having an independent currency increase with the number of users (Levy-Yeyati et al., 2004).
Thus, one would assume for small economies to be better candidates for a regime of fixed
exchange rates. Empirical evidence confirms theoretical predictions, with only one country among
15 dollarizers and 7 currency boards having a population over 10 million (Ecuador) and the
average population being approximately 3 million.
Geographical concentration of trade: While the extent of trade is the most important factor in
determining if a country should peg its currency, the geographical concentration of trade has to be
taken into consideration as well (Larrain and Velasco, 2001). Countries that predominantly
conduct their trade with one major partner derive a greater benefit from pegging their currency (to
the partner country) than countries with a highly diversified trade base.
Asymmetric shocks: Basic economic theory states that if 2 or more countries face similar
shocks that require similar policy interventions, then the adoption of a fixed exchange rate and a
common monetary policy should not have far-reaching negative consequences for either region.
On the other hand, if 2 countries face asymmetric shocks, a common monetary policy will not be
able to suit both regions, and adjustments of the real exchange rate would be needed to
accommodate differences, which would call for flexible exchange rates. As a corollary, countries
considering pegging their currency should share a similar business cycle with their partner
country to limit the incidence of asymmetric shocks (Frankel, 2003).
Other OCA criteria: As mentioned above, even in the presence of asymmetric shocks there are
factors that can limit their magnitude under fixed exchange rates. High labour mobility, price and

19


wage flexibility, as well as fiscal transfers each provide adjustment mechanisms to cope with
asymmetric shocks in the absence of exchange rate flexibility (Frankel, 2003).
Strategic considerations: The optimal exchange rate regime for a country does not only depend
on its own characteristics, it also depends on the surrounding environment, in this case the
exchange rate arrangements of neighbors, competitors, and trade partners. By pegging to a major
currency, currency risk can be eliminated with the anchor economy, but it also means that the
economy is floating vis-à-vis all other currencies. This especially poses a problem for fixed
economies in a “neighborhood” of floaters (Larrain and Velasco, 2001). In this context the
example of Argentina is instructive. In 1999, Brazil faced a large depreciation of its currency. As
a result Argentina suffered a large loss of international competitiveness vis-à-vis its main trading
partner Brazil, which was one of the factors attributing to the severe recession and possibly to the
collapse of the currency board (Salvatore, 2002). Thus, one could assume that the number of
floating regimes in geographic and economic proximity decreases the attractiveness of fixing the
exchange rate.

The Optimal Currency Area theory can provide some helpful insights in evaluating if a country
is a good candidate to join a monetary union or to fix its exchange rate. But an evaluation based
solely on the OCA criteria would be incomplete. Moreover, the OCA theory also has its
drawbacks. First, the European Monetary Union has managed to function successfully although it
certainly does not form an optimal currency area. This has led many economists to believe the
OCA criteria are too stringent. “The point is that the requirements for having single money
developed by the optimal currency literature are so demanding as to call into question many
existing currency areas” (Fratianni and Hauskrecht, 2002, p.251-252). Second, the currency crises
in emerging market economies of the recent past have shown that international capital flows play
an increasingly important role in an increasingly integrated world. Unfortunately the OCA
approach does not take the role of financial markets and capital flows into account. Third and
most importantly, the OCA approach fails to incorporate features and characteristics that are
crucial to emerging market economies, such as, among others, credibility issues, weak
institutions, higher pass through effects and a dependency on foreign capital (Calvo and Mishkin,
2003).
For the reasons stated above, I would see the OCA approach more as a complementary tool in
the analysis and evaluation of exchange rate regime for emerging markets. In the next chapter I
will discuss the problems that are specific to emerging market economies and how they might
influence the choice of exchange rate regime.

20


5. Emerging Market Issues

In many ways emerging market economies are victims of their past. Many of them, especially in
Latin America, have a history of high inflation owing primarily to the monetization of budget
deficits. Other factors such as corruption, political instability and broken promises from the
monetary authority have also certainly not encouraged price stability as well as economic stability
and development. Such events have severely damaged the image and credibility of domestic
institutions. Unfortunately, well-developed and well-run institutions are a necessary prerequisite
for the success of an exchange rate regime. Especially a credible central bank is crucial in order to
conduct a successful monetary policy. Even if a firm commitment is made towards price stability
and a “sound and correct” monetary policy is installed, this may not be enough to sufficiently
lower the public’s inflation expectations, due to a large distrust from past events.
The lack or lacking quality of political, fiscal, financial and monetary institutions paired with
the fact that large fluctuations in the exchange rate are more detrimental to the economies of
developing countries than to those of industrial countries (Salvatore, 2002, Corden, 2002), has
led many economists in the past to believe that developing countries and emerging market
economies have little to gain from a flexible exchange rate and an independent monetary
policy and, thus, would be better off adopting a foreign monetary policy and thereby fixing
their exchange rate. However, at first sight, recent trends in the popularity of exchange rate
regimes do not seem to support this view (Hakura, 2005, Frankel, 2003). Frankel (2003), for
example, observes a clear trend toward increased flexibility over the last 30 years, with the
vast majority of regimes being classified as intermediate. Unfortunately, these findings are
based on a de jure classification, with the actual/de facto behaviour of regimes not necessarily
corresponding to their classification. In reality many as managed floating or floating
announced regimes have shown a reluctance to let their exchange rate swing (freely), dubbed
as “fear of floating” by Calvo and Reinhart (2002) (table 11 and 12). But, as Calvo and
Reinhart (2002) note, it is very difficult to distinguish exchange rate regimes in general, and
regimes in the intermediate border region, say a managed float from a soft peg, in particular.
Nonetheless, empirical evidence indicates that floating exchange rate regimes in emerging
markets are more rigid than in their industrial counterparts and their de facto behaviour
indicates that they, to a certain extent, have been importing the monetary policy and
credibility of foreign countries, thereby deliberately limiting the advantages of flexibility.

21


5.1. Credibility

A central issue in the debate on exchange rate regimes in emerging markets is the credibility of
domestic institutions, especially the credibility of the central bank’s commitment to price stability.
Blinder (1999, p.1) offers a simple definition of credibility: “A central bank is credible if people
believe it will do what it says.” Thus, credibility cannot be measured in statistical terms. However,
inflation performance and inflation history reveal a great deal about an economy’s credibility. Past
mistakes and failures have nagged on the credibility of monetary institutions in emerging markets
and have negatively influenced expectations and behaviour of the public. The credibility of the
monetary authority, however, does not only depend on its own actions, it also hinges on the
quality of the other institutions. For instance, large fiscal deficits, an ill-supervised banking
system and political instability all could cause large damage to an economy, so that the
commitment towards price stability has to be subordinated to a stabilization policy, possibly
causing unwanted inflation. Unfortunately, every time the central bank fails to preserve (expected)
price stability, it will become increasingly less credible. As a corollary, the public in countries
with weak central bank credibility will not take the real value of money for granted (Calvo and
Mishkin, 2003) and eventually will protect themselves by, for example, using a foreign currency
as a store of value and/or indexing their wage contracts to the rate of inflation or the exchange
rate. Moreover, high inflation and frequent depreciations of the domestic currency increasingly
undermine the effects of monetary policy on the real economy, while concomitantly increasing the
effects on inflation and nominal interest rates.
Thus, for economies starting from a situation, where the public questions the credibility of the
monetary authority, fixed exchange rate regimes hold an advantage over flexible regimes. By
implementing a hard peg, an economy instantaneously imports the credibility and monetary
stability of the country it pegged its currency to, helping to quickly reduce inflation. On the other
hand, flexible exchange rates will have to “build” that credibility by themselves, which is needless
to say by far the more difficult process (Larrain and Velasco, 2001). In contrast to hard pegs, the
possibility of inflationary finance can never be totally ruled out. Hence, for emerging market
countries with recurring inflation problems an absolutely fixed regime can provide more
credibility than a floating regime (Corden, 2002).
However, some economists question the desirability of fixed exchange rate regimes and see them
as second best solutions, or rather as the consequence of economies with weak institutions that are
not able to solve their credibility problems on their own (Levy-Yeyati et al., 2004). “In the case
of unilateral dollarization or euroization, stability is imported because previously unstable
countries are not able to implement necessary monetary and fiscal reforms that lead to stable

22


economic development on a credible and permanent basis”(Volbert and Loef, 2002, p306).
Empirical results by Levy-Yeyati et al. (2004) suggest that the propensity to peg is higher for
developing economies with low institutional quality, relying on the exchange rate anchor to
compensate for low credibility.
While the advocates of fixed exchange rates stress the inflation reducing capabilities of fixed
exchange rate regimes due to the enhanced credibility and discipline, the adoption of such a
regime for countries with high inflation is nonetheless somewhat of a paradox (IMF, 1997).
Essentially high rates of inflation and a fixed exchange rate are not sustainable. Developing
countries with a fixed exchange rate and a higher rate of inflation than the country they
pegged to will experience a real appreciation of their exchange rate, which reduces their
international competitiveness and also leads to a worsening of the current account (IMF,
1997). As a result, the peg will become misaligned, putting pressure on the exchange rate and
the financial sector, eventually making an adjustment of the exchange rate inevitable. The
relative short duration of most exchange rate pegs12 indicates that fixing the exchange rate
entails problems of its own, such as a loss of competitiveness, and is not an everlasting
solution for economies with credibility problems.

Credibility problems per se can arise both under flexible and fixed exchange rate regimes. But
they differ due to the different objectives of monetary policy.
Under flexible exchange rates, the commitment to price stability determines the credibility of
monetary policy. Thus, the monetary authority will have to convince the public that they are only
committed to the pursuit of their policy targets and that excessive inflation will not occur again.
Under flexible exchange rates the best way to achieve this is by using an inflation targeting
policy. Credibility enhancing measures include providing the public with detailed information on
inflation results, targets and forecasts, current and future policies as well as possible obstacles
(Mishkin, 1999). But ultimately, the credibility of flexible exchange rate regimes will increase the
longer they are successfully able to preserve price stability (Corden, 2002, Mishkin, 1999).
In contrast to flexible regimes, under fixed exchange rates price stability is not a direct issue. By
fixing the exchange rate, an independent monetary policy is given up and the commitment to price
stability is imported with the monetary policy of the anchor currency country. Thus, the exchange
rate serves as the nominal anchor for monetary policy and the credibility depends on the
commitment to the exchange rate peg, or put in other words, on the public’s perception of the
chances that the fixed exchange rate will be abandoned. A high level of foreign reserves increases
a country’s ability to defend a fixed exchange rate and thereby enhances the credibility of the peg.
12
See, for example, IMF (1997)

23


But ultimately, the larger the economic and political costs associated with a collapse of the peg,
the higher will the incentive be for the government to defend the regime, which in turn will
increase its credibility (Schuler, 2000). Credibility can also be seen as an indicator of the rigidness
of a fixed regime and vice versa, with hard pegs profiting from the benefits of high credibility and
soft pegs, with their escape clauses, profiting less from credibility but instead deriving benefits
from their enhanced flexibility (Schuler, 2000, Larrain and Velasco, 2001).
The choice of exchange rate regime hinges to a great part on the credibility of a country’s
monetary and the quality of its other institutions. Weak institutions and a central bank that lacks
credibility towards price stability do not favour the adoption of flexible exchange rate regimes.
However, a qualification must be noted, countries with large fiscal imbalances in the long-run
have no other choice than to opt for a regime with floating exchange rates (Corden, 2002).

5.2. Access to International Financial Markets

A problem that is linked to the lacking credibility of monetary and fiscal policies in
emerging markets is their access to international financing compared with developed
economies (Calvo and Reinhart, 2000). In the past, emerging market countries have been highly
dependent on foreign international capital to finance their growth due to the relatively shallow
domestic financial markets (Calvo, 1999). Lower credibility translates into lower credit ratings,
which in turn means emerging markets will have to offer higher interest rates in order to
attract funds. Using the credit ratings of two internationally renowned agencies, Moody’s and
Institutional Investor, for a sample of 25 countries during a 30 year time period, Calvo and
Reinhart (2000) observe that the level of credit ratings for emerging markets is on average a
third to half of that assigned to developed economies. Furthermore, the authors show that
following a large devaluation of the domestic currency emerging markets experience a far
greater credit rating downgrade than developed economies.13 However, the devaluations and
associated credit downgrading are not always the result of weak domestic polices. They can
be caused by factors external to a domestic economy, most notably contagion, as the
experiences from past crises have shown (IMF, 2003). As a consequence of the lower credit
rating international investors will demand a higher yield (Calvo and Reinhart, 2000) and
emerging markets will face higher debt-servicing costs associated with a higher chance of

13
“In the twelve months following the currency crisis, the magnitude of the downgrade is about five times
greater for emerging markets than it is for developed economies. The differences between the post-crisis
downgrade for emerging and developed economies is significant at standard confidence levels. ” Calvo and
Reinhart (2000, p13)

24


default and additionally putting considerable stress on the already rather weak financial
system. Alternatively, if interest rates are not raised sufficiently, the emerging market will not
be able to attract foreign capital and the economic contraction will be more pronounced.
Thus, devaluations in emerging markets lead to a limited access to international funds or to
borrowing costs that might jeopardize the health of the financial system, both of which help
deliver a possible explanation as to why emerging markets are reluctant to face large
exchange rate swings.

5.3. Sudden Stops and Currency Crises

While the incidence of sudden stops is neither a new nor a rare phenomenon, and certainly
not one that is limited to emerging market countries, sudden stop issues have really come to
the fore in context with the financial and currency crises to emerging market economies of the
past decade. The affected countries faced large devaluations of their currencies and the
volatility of capital flows became a serious problem as capital inflows ceased and in some
countries even reversed. While there are several different definitions of a sudden stop, a
sudden stop initially refers to a large decline in capital inflows to a country. However,
economic literature tends to focus on the cases where a sudden stop in capital inflows is
accompanied by a contraction in output. The reasons for this decline in capital inflows can
vary and be of domestic origin, such as political instability, banking and currency crises, or of
external origin, such as changes in international interest rates or contagion (Guidotti et al.,
2004). However, the latter seems to be of greater importance as the incidences of emerging
market sudden stops in the past decade were not uniformly distributed, but rather were
bunched around periods of emerging market crises (Calvo et al., 2004). Furthermore,
countries that were simultaneously affected by sudden stops were quite heterogeneous in their
macroeconomic fundamentals as well as in their geographic location.
To take a closer look at the effects of sudden stops, it is helpful to take a look at the national
economic accounts:

Y- E ≡ CA (NX)

- CA + ∆R ≡ KA

Where Y denotes income, E is absorption/aggregate demand, CA the current account, KA
the capital account, and ∆R the change in international reserves.

25


By definition, net capital inflows must match the current account deficit and the change in
international reserves. Hence, a reduction in capital inflows, will result either in an
amelioration of the current account and/or a loss of reserves. A reduction of reserves reduces
a country’s capability to control its exchange rate, thereby increasing the likelihood of
speculation and a currency crisis, while an amelioration of the current account in the wake of
a sudden stop is mostly compensated by a fall in aggregate demand and, thus, has negative
consequences on employment and output (Calvo and Reinhart, 2000). Indeed, findings of
Calvo et al. (2004) support traditional economic theory, as they observe that sudden stops are
associated with reserve losses and large current account adjustment as well as large upswings
in interest rates.
A key distinction between developing and developed countries is that empirical evidence
indicates that large real depreciations in emerging markets are usually associated with sudden
stops, whereas in developed economies this phenomenon is rather rare (Calvo et al., 2004).
This suggests “large real exchange rate fluctuations accompanied by sudden stops are
basically an emerging market phenomenon” (Calvo et al., 2004).
Calvo and Reinhart (2000) investigate the effect of currency crises on the incidence and
magnitude of sudden stops, as well as the effect on output. They take a closer look at 96
currency crises, of which 25 occurred in developed economies and the remaining 71 in
developing countries. Regarding a two year time period for every currency crisis, with the
first year preceding the crisis and the last succeeding it, the authors conclude that a currency
crisis leads to an improvement of the current account and a reduction of growth in both types
of economies. But, the authors also find that the magnitude of sudden stops, measured as
current account adjustment during the time period, and growth reduction differ significantly
between developed and developing economies, both economically and statistically. The
difference in current account adjustment is five times larger (3.5% compared to 0.7%) for
developing economies14, while the growth reduction is 2% compared to 0.2% for developed
economies during the two year time period. The authors see the main reason for the larger
economic damage of currency crises and the occurrence of sudden stops in emerging markets
in their inability to generate sufficient funds, which is caused by the acute deterioration of
borrowing conditions and associated loss of access to international finance due to lower credit
ratings, and the relative shallow domestic financial markets.

14
Guidotti et al. (2004) and Calvo et al. (2004) also find developing countries are associated with much larger
adjustments in the current account than developed economies.

26


Looking for factors that influence the occurrence of sudden stops Frankel and Cavallo
(2004) find that openness significantly reduces the probability and the associated costs of a
sudden stop (and currency crisis), whereas a large initial current account deficit increases the
probability. Calvo et al. (2004) find that trade openness (negatively) and domestic liability
dollarization (positively) are the key determinants of the probability of sudden stops. While
Guidotti et al. (2004) find that low levels of liability dollarization, floating exchange rates and
a high level of openness are conducive to a rapid recovery from a sudden stop.
Other factors influencing the incidence of sudden stops, such as political instability and
contagion, occur regardless of the exchange rate regime in place. However, as mentioned
above, currency crises often appear together with sudden stops and the former do seem to be
linked to the choice of exchange rate regime (Mussa et al., 2000). Rogoff et al. (2003) using a
de facto classification of exchange rate regimes find that twin (banking and currency) crises in
emerging markets occurred more often in pegged regimes and that their incidence decreased
with increasing flexibility of regimes.

5.4. Trade Issues

The standard trade invoicing rule among industrialized countries that goods tend to be
denominated in the currency of the exporting country (McKinnon, 1999) does not apply very well
to emerging market economies. Instead, international trade involving an emerging market
economy is usually invoiced in the currency of the larger economy. Moreover, very often
trade among emerging market economies is invoiced in dollars or euros (Clark et al. 2004,
30). Goldberg and Tille (2004) show that while the share of exports invoiced in the currency
of the exporter is above 90% for the United States, and above 50% for the UK, Germany and
France, the emerging market economies of Korea and Thailand exhibit a share below 10%.
Studies analyzing the effect of exchange rate variability on trade in emerging markets15 seem
to lean towards the hypothesis that exchange rate variability has a negative effect on trade,
which is arguably larger than in industrialized economies (Calvo and Reinhart, 2000). Clark
et al. (2004) find that volatile exchange rates are more likely to be associated with smaller
trade for developing countries than for advanced economies. However, their results are not
very robust; the introduction of time varying effects in the regression erodes the impact of
volatility on trade flows. Arize et al. (2000, 2005) come to the conclusion that there is a

15
For an overview of the literature, see Calvo and Reinhart (2000), p.16.

27


negative and statistically significant relationship between export flows and exchange-rate
volatility in both the long- and short-run in each of the thirteen less developed countries and
eight Latin American countries in their respective studies. Broda and Romalis (2003) find that
the depressing effect of volatility on exports is greater for emerging markets than for
developed economies.
While the reasons for the alleged vulnerability of emerging markets to swings in the
exchange rate are manifold and could range from the trade invoicing patterns over limited
hedging possibilities to a higher risk adversity of exporters, empirical evidence suggests that
reducing exchange rate variability could enhance trade, especially for emerging markets.

5.5 Effectiveness of Monetary Policy

In the past, most emerging market economies and developing countries have not been able to
derive a great profit from using discretionary monetary policy, or have used monetary
independence for other purposes than in industrial countries. Hausmann et al. (1999) come to the
conclusion that flexible exchange regimes neither deliver much insulation from shocks nor
provide much room for monetary policy autonomy, while lacking the credibility of hard pegs.
A history of high inflation and/or lacking central bank credibility have taken the “surprise” out
of surprise inflation, so that countercyclical monetary policy does not have the desired effect on
output and unemployment in many emerging market countries (Larrain and Velasco, 2001).
Furthermore, the dependency of emerging markets on foreign capital and the higher volatility of
international capital flows complicate the conduct of a monetary policy. In times of economic
downturn, interest rates, and hence monetary policy, often do not take domestic considerations
into account and behave in a procyclical manner to preclude an outflow of foreign capital and help
stabilize the exchange rate (Calvo and Reinhart, 2002). An additional difficulty has been that tax-
collecting systems in many developing countries have proven to be inefficient and weak, with tax
evasion being widespread. With the fiscal base being very small, a discretionary monetary policy
often has been misused in the past as an additional source of revenue through the inflation tax
(Calvo and Reinhart, 2002).

5.5.1. Monetary Independence

Following conventional economic theory, one would expect monetary independence to be
greater under floating exchange rates, as interest rates can be set independently and are not

28


determined by foreign policies as in the case of fixed exchange rates (Frankel et al., 2002).
However, empirical evidence is far less clear-cut than economic theory.
Shambaugh (2004) finds evidence for the notion of the impossible trinity. In a sample of over
100 developing countries divided into de facto pegs and non-pegs from 1973 through 2000, the
author finds that the exchange rate regime along with capital controls seem to explain the extent to
which a country follows foreign interest rates. For developing countries pegging significantly
increases sensitivity to foreign interest rates, while capital controls (for fixed regimes) do the
opposite. Further important findings are that in pegged regimes interest rates are lower and more
stable, while in non-pegged regimes foreign interest rates are not a good indicator of domestic
monetary policies, implying that these countries have a reasonable amount of monetary autonomy.
Frankel et al. (2002) analysing a sample of 18 industrial and 28 developing countries over a time
period from 1970-1999 find that results for the entire sample confirm conventional wisdom, with
floating regimes displaying less sensitivity to foreign interest rates and fixed regimes displaying
lower interest rates. However, in the 1990s both industrial and developing countries displayed full
or near-full adjustment of local interest rates to foreign interest rates, with fixed regimes
displaying a significant over-adjustment. While developing countries, regardless of their regime,
adjusted to interest rates set in the financial centres, countries with flexible rates did appear to
have a higher degree of monetary independence, albeit temporary, as hard pegs displayed a
quicker adjustment than other regimes.
In an attempt to measure monetary independence Borensztein et al. (2001) compare the currency
boards of Hong Kong and Argentina with the floating regimes of Singapore and Mexico during
the 1990s. This country comparison entails the advantage that the country pairs share broad
similarities and that classification problems can be circumvented, as the floaters do not exhibit
much fear of floating. Additionally for benchmark purposes the authors include the industrialized
floating economies of Canada, Australia, and New Zealand as well as Chile. Using VAR models
the results obtained are broadly consistent with the view that floating regimes deliver more
monetary independence. While all 4 economies displayed a significant impact of changes in US
interest rates on domestic interest rates, the effect was significantly larger for the currency boards.
Additionally, shocks to emerging market risk premia had smaller effects in Singapore than in
Hong Kong, however, contrary to the conventional view, interest rate reactions to such shocks
were nearly identical in size for the economies of Mexico and Argentina. Hausmann et al. (1999)
find that the reaction of domestic interest rates in 11 Latin American countries is similar across
different regimes for a time span from 1960-1998. Moreover, for a short 2-year time span from
1998-1999, the authors find that changes in international risk premia had the largest effects on

29


interest rates in the floating regime of Mexico16. However, unlike Borensztein et al. (2001) the
authors did not control for exchange rate movements, thereby biasing the interest rate effect
upwards.
A possible explanation for the lacking insulation flexible regimes provide regarding increases in
interest rate premia is a lack of credibility, typically associated with flexible regimes, which
offsets the increased flexibility and independence advantages flexible regimes initially possess
(Calvo and Reinhart, 2002). In countries where expectations about future inflation and exchange
rate development are volatile and uncertain, interest rates are likely to be high and volatile. Risk
premium shocks will unleash fears of devaluation and default, which typically will be greater
under a flexible regime (that lacks credibility) than under a fixed regime, forcing a greater
adjustment of domestic interest rates and thereby possibly explaining the higher variance of
interest rates to risk premium shocks in some floating emerging markets. Indeed, reviewing the 3
emerging market floaters Singapore, Chile and Mexico documented in Borensztein et al. (2001),
the 2 economies that displayed increased monetary independence, Singapore and Chile, had low
levels of inflation, while Mexico did not.

Figure 5: Inflation in Mexico,
Chile and Singapore
40%

30% However, focusing solely on

20%
domestic interest rate
movements can underestimate
10%
the actual degree of monetary
0% independence, as high interest
92 93 94 95 96 97 98 99 00
Chile Mexico Singapore rate sensitivity could be caused
source: IMF WEO database
by similar business cycles
and/or similar shocks. Capital controls also play a decisive role as they increase monetary
autonomy under fixed exchange rates. Fear of floating also limits monetary autonomy as
economies deliberately decide to limit exchange rate variability by using the interest rate as an
instrument for this purpose (Frankel et al., 2002). However, floating regimes under inflation
targeting use interest rates as a policy instrument, and therefore it is very difficult to quantify
their actual amount of monetary independence (Calvo and Reinhart, 2002).
Although the empirical evidence is mixed and measuring the amount of monetary
independence an individual country possesses is a difficult and complicated procedure, a

16
Hausmann et al. (1999, 12) find that a 1% increase in foreign interest rates leads to a 1.45% increase in
Argentina and a 5.93% increase in Mexico.

30


number of studies seem to support the “conventional” view that floating reduces the need to
adjust domestic interest rates in response to external shocks. Likewise empirical evidence
suggests that this increased autonomy comes at the cost of higher average interest rates.
However, floating exchange rates do not necessarily provide emerging markets with increased
monetary independence, as lacking credibility of domestic policies can more than offset the
advantages of increased flexibility.

5.5.2. Is Expansive Monetary Policy Contractionary?

Advocates of fixed exchange rate regimes argue that in the past devaluations or large
depreciations of the domestic currency in emerging markets were not expansionary, as
suggested by standard textbook models, but in fact tended to be contractionary (Calvo and
Reinhart, 2000).
Conventional wisdom predicts that in the short run nominal devaluations are thought to be
contractionary, while in the long run they are expansionary (Corden, 2002). While in the short
run the absorption reducing effect dominates, in the long run the stimulating effect of
improved competitiveness on exports kicks in. However, the effect of devaluation also
depends on the structure of an economy. Corden (2002) sees unhedged foreign currency
liabilities and reductions or even reversals of capital flows as the principal reasons for the
predominantly contractionary effects of devaluations in emerging markets, as they increase
the negative effect on domestic absorption. Similarly, Calvo and Reinhart (2000) see
emerging markets’ loss of access to capital markets and their pervasive liability dollarization
mainly responsible for devaluations having a contractionary character.
Empirical evidence indicates that indeed the majority of devaluations were in fact
contractionary17. Gupta, Mishra, and Sahay (2003) using a sample of 195 crises episodes in
91 developing countries during 1970-98 find that 43 percent were expansionary, that the
corresponding share of crises was 30 percent for large emerging markets, and that this ratio as
well as the magnitude of contractions has remained relatively unchanged throughout the 3
decade time period. The authors find the volume of capital flows, the cyclical situation, the
level of per capita income, and the ratio of short-term debt to reserves negatively influence the
output response. On the other hand a larger tradable sector and export growth, which in turn is
negatively influenced by simultaneous devaluations of other countries, are found to increase
the expansionary effect.

17
For an overview of empirical literature and results on this topic, see Gupta et al. (2003).

31

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