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Federico Sturzenegger (*)
The proper assessment of the costs and benefits of alternative exchange rate regimes has been a hotly debated issue and remains perhaps one of the most important questions in international finance. The theoretical literature has concentrated on the trade-off between monetary independence and credibility implied by different exchange rate regimes, as well as in the insulation properties of each arrangement in the face of monetary and real shocks. (1) Recent episodes of financial distress have refocused the discussion by introducing the question of which exchange rate regime is better suited to deal with increasingly global and unstable world capital markets. (2) In particular, given the increasing importance of international capital flows and the predominance of external over domestic monetary shocks, the traditional trade-off has narrowed down to a price stability-growth dilemma, according to which fixes are expected to enhance the credibility of noninflationary monetary policies, reducing inflation and the v olatility of nominal variables, while floats are seen as allowing the necessary price adjustments in the face of external (real and financial) shocks, reducing output fluctuations and improving growth performance.
The terms of the debate about exchange rate regimes and the views prevalent in policy circles have evolved over time, as they have rarely been independent from the characteristics of international financial markets. In the 1980s, in a context of relatively closed capital markets, external shocks were less relevant and, with many countries struggling with disinflation policies, monetary aspects appeared to be much more important than today. The issues stressed in the academic literature have changed accordingly: while economists in the 1980s concentrated on studying the implications of exchange rate regimes as stabilization instruments (or as credibility enhancers), today the debate focuses on how different regimes may act as absorbers of external shocks or provide a shield against speculative attacks. (3)
The lack of consensus on the subject has been paralleled by recent developments in the real world. Recent years have witnessed an unprecedented number of changes of exchange rate regimes, in a way that seems to provide partial support to almost any view about the long-run trends in the choice of regimes. Thus, while the inherent vulnerability of intermediate exchange rate arrangements to sudden aggregate shocks revealed by the notorious collapses of pegs or managed floats in Southeast Asia and Latin America have suggested to some observers the convenience of more flexible regimes, a number of countries have taken the opposite path, moving toward monetary unions or unilateral dollarization, as was the case in Europe in the aftermath of the European Monetary System (EMS) crisis of 1992, or in Ecuador with the recent adoption of the U.S. dollar as legal tender.
The debate is further complicated by another important consideration: Characterizing the exchange rate regimes actually in place in different countries is not a trivial task. Calvo and Reinhart (2000), for example, have pointed out that many countries that claim to be floaters intervene heavily in exchange rate markets to reduce exchange rate volatility, suggesting a mismatch between de jure and de facto regimes. Similarly, Levy-Yeyati and Sturzenegger (2000a) highlight the recent increase in what could be labeled "fear of pegging": countries that run a de facto peg but avoid an official commitment to a fixed parity. (4)
With all this in mind, in this paper we revisit the inflation-growth trade-off, using an extensive database that includes 154 countries and covers the post-Bretton Woods era. We deliberately ignore the Bretton Woods period in which fixes were dominant, largely for political reasons, to concentrate in the recent period of increasing financial integration, in which, we believe, the linkage between exchange rate regimes and the real economy better reflected the choice of individual countries' monetary authorities.
Several new aspects are introduced in our analysis. First, we use a de facto classification, described in detail in Levy-Yeyati and Sturzenegger (2000a) (henceforth denoted LYS), that groups exchange rate regimes according to the actual behavior of the main relevant variables, as opposed to the traditional classification compiled by the TMF based on the de jure (i.e., legal) regime that the countries' authorities declare to be running. (5) By doing this, we refine the analysis substantially. On the one hand, we avoid the misclassification of pegs that pursue independent monetary policies (and eventually collapse) and floats that subordinate their monetary policy to smooth out exchange rate fluctuations, which may bias the statistics of the tests toward lack of significance or incorrect interpretations. On the other hand, the new classification makes a distinction between high and low volatility economies, providing a natural way to discriminate the impact of the regime in tranquil and turbulent times.
Second, we distinguish between "long" and "short" pegs; long pegs are defined as those in place for five or more consecutive years and short pegs as those in place for less than five years. We find the distinction useful at least in two respects. On the one hand, it allows us to determine whether the impact on macroeconomic variables is a product of the regime in place or rather the result of the short-run effect of a regime switch. On the other hand, our focus on long pegs addresses the concern that the poor showing of many conventional pegs may be mainly attributable to countries with weaker macroeconomic and political fundamentals that are forced to implement ultimately unsustainable fixed exchange rate regimes.
Third, in addition to looking at the inflation-growth trade-off, the paper examines the impact of exchange rate regimes on the cost of capital, as measured by the real interest rate, something that has not been done yet in the literature, to our knowledge. The issue has important policy implications inasmuch as lower interest rates are typically invoked as a key argument in favor of fixed exchange rates and, more recently, of the full adoption of a foreign currency as legal tender.
Fourth, we conduct a "deeds vs. words" comparison that makes use of both the LYS and the IMF-based classification, which sheds light on a number of issues. For example, it allows us to test the extent to which economic performance is determined by the actual (as opposed to the reported) exchange rate policy, as well as the "announcement" value of a de jure peg, above and beyond the actual behavior of the regime.
Finally, we test whether fixed exchange rate arrangements that imply a harder commitment, such as currency boards or currency unions (a group usually referred to as "hard" pegs), are different from (and better than) conventional fixes and other regimes in general. This increasingly popular hypothesis stresses that the stronger commitment embedded in a hard peg reduces the vulnerability of the regime to speculative attacks (thus enhancing growth) while reaping all the benefits in terms of lower inflation. (6)
The main findings discussed in the paper are the following:
1. For industrial countries, we find no significant link between regimes and economic performance.
2. For nonindustrial economies, a robust association between fixed regimes and lower inflation rates appears only when we focus on long pegs. This link seems to work both through its influence on monetary growth and through its impact on expectations. Moreover, deeds rather than words matter for inflation: The announcement of a fixed exchange rate regime has an impact on inflation only in the case of long pegs.
3. Real rates appear to be lower under fixed exchange rate regimes than under floats only according to the de jure classification, suggesting that the result is mostly due to the role of unanticipated devaluations. Interestingly, for de facto pegs, we find that the announcement of a fixed regime has a negative effect on real interest rates only for short pegs, possibly because short pegs, while effective in reducing inflation expectations (and thus nominal interest rates), are not effective in reducing actual inflation (point 2 above).
4. Within the group of nonindustrial countries, pegs (both short and long) are significantly and negatively related to per capita output growth. Thus, the inflation-growth trade-off implicit in the choice between fixed and floating regimes seems to apply only to long pegs. In contrast, short pegs clearly underperform floats: they grow more slowly without providing significant gains in terms of inflation.
5. Hard pegs deliver better inflation results than conventional pegs, but they do not eliminate the inflation-growth trade-off, as they still display significantly smaller growth rates than floating exchange rate arrangements.
6. Compared with de facto floats, de facto pegs that shy away from legally committing to a fixed exchange rate benefit from higher growth performance, providing a justification for the "fear of pegging."
The plan of the paper is as follows. Section I succinctly describes the LYS and IMF classification used in the econometric tests. Section II presents the data. Section III shows the main empirical findings for inflation and money growth. Section IV discusses the impact of regimes on real interest rates. Section V looks at the relation between regimes and growth. Section VI explores whether hard pegs behave differently from conventional pegs. Section VII outlines some areas for future research and concludes.
I. Exchange Rate Regime Classification
The LYS de facto classification (7) that we used in this paper is based on three variables closely related to exchange rate behavior: (1) exchange rate volatility [[sigma].sub.e], measured as the average of the absolute monthly percentage changes in the nominal exchange rate during the year; (2) volatility of exchange rate changes [[sigma].sub.[DELTA]e], measured as the standard deviation of the monthly percentage changes in the exchange rate; and (3) volatility of reserves [[sigma].sub.r], measured as the average of the absolute monthly change in international reserves relative to the monetary base in the previous month. (8)
Underlying the LYS classification is the idea that, according to the behavior of these three variables, we should be able to identify the exchange rate regime that a country is actually following. For example, a textbook flexible exchange rate regime is characterized by little intervention in the exchange rate market together with high volatility of exchange rates. Conversely, a fixed exchange rate regime should display little volatility in the nominal exchange rate while reserves fluctuate substantially. Finally, an intermediate regime corresponds to the case in which volatility is relatively high across all variables. (9) Table 1 summarizes the patterns that, a priori, should be expected for the different regimes in terms of the three classification variables.
Note that countries that do not display significant variability in either variable are denoted "inconclusive." Two reasons underlie this label. The first relates to the fact that it is virtually impossible, in the absence of shocks, to assess how exchange rate regimes will actually behave when put to a test. The second derives from the hypothesis that countries that do not face sizable shocks should be less informative about the real impact of the regime, and that their inclusion in our econometric tests may bias the regime coefficients downward.
Once the three classification measures are computed for our universe of countries, the points corresponding to each country-year observation are assigned to the different groups of Table 1 using K-Means Cluster Analysis. (10) Finally, countries grouped in the "inconclusive" category are reclassified in a second round using exactly the same procedure. (11) This two-stage procedure allows us to differentiate first- and second-round regimes, in turn associated with high and low volatilities in the underlying classification variables. (12)
As we mentioned above, we also conduct our tests using an IMF-based classification for the purpose of comparison with previous work, as well as to address issues related to the announcement value of an exchange rate regime, particularly in the case of pegs. (13) The IMF has changed the way it classifies exchange rate regimes over the years. Before 1998, the IMF grouped countries into three basic categories: pegs, limited flexibility, and more flexibility, in turn divided into several subgroups. After 1998, the IMF moved to an eight-way classification: no separate legal tender, currency boards, conventional fixed, horizontal bands, crawling pegs, crawling bands, dirty float, and free floats. In general, however, the categories can be readily mapped on a simpler grouping that includes different forms of pegs (to a single currency, or to a disclosed or undisclosed basket), intermediate regimes (crawling pegs, bands, managed floats, cooperative arrangements), and pure floats.
Levy-Yeyati and Sturzenegger (2000a) discuss at length the nature of the mismatches between both classifications. In particular, they show that their number for any given year hovers around 50 percent of all cases. The IMF has recently started to acknowledge the difference between deeds and words by reporting, in some cases, countries with a formal regime and a different de facto one. These regimes are identified by the superscript 6 in IMF (1999). In what follows, we deliberately ignore this distinction when considering the IMF classification and assign countries according to their "legal" arrangement.
II. The Data
Our sample covers annual observations for 154 countries over the period 1974-99. A list of countries, as well as the definitions and sources of the variables used in the paper, is presented in Appendix I. With the exception of the political instability and secondary school enrollment variables used in the growth regressions, all of our data come from the IMF and the World Bank. Data availability varies across countries and periods, so the tests in each subsection were run on a consistent subsample of observations (which is reported in each case along with the results).
The LYS de facto classification covers a sample of 2,825 observations, of which 637 are labeled inconclusive in the second round. Table 2 shows the distribution of the remaining 2,188 observations, along with the alternative IMF-based classification for the same group of observations.
III. Inflation and Money Growth
A First Pass at the Data
The typical association of fixed exchange rates with lower inflation rates is based primarily on the belief that a peg may play the role of a commitment mechanism for monetary authorities, inasmuch as an expansionary monetary policy is inconsistent in the long term with a fixed exchange rate, and that the failure to comply with the commitment entails some political cost to the authorities (Romer, 1993, and Quirk, 1994). To this effect, which should work entirely through the behavior of the monetary aggregates, the literature adds the potential impact of a credible peg on inflation expectations, which might stabilize money velocity and reduce the sensitivity of prices to temporary monetary expansions. In this way, a fixed exchange rate regime is expected to affect the link between money and prices. Similarly, particularly in those cases in which dollar indexation is widespread, a credible peg may help reduce inertial inflation by placing a limit to devaluation expectations.
Table 3 provides a first pass at the data. The table shows the means and medians of inflation for each of our control groups, namely, the floating, intermediate, and fixed exchange rate regimes according to the IMF and the LYS classification (the latter being further disaggregated into first and second rounds). For consistency, the sample of 1,925 observations comprises all countries and years classified by LYS (see Table 2) for which data on inflation and monetary growth are available. Because the sample includes many countries that exhibit extraordinarily high inflation, it seems reasonable to concentrate the analysis in the medians, which are less affected by such extreme values.
For both classifications, the intermediate regimes are the ones that fare the worst in terms of inflation. However, important differences emerge when comparing fixes and floats. Whereas the IMF index seems to indicate, quite surprisingly, that fixes are associated with slightly higher inflation levels, the result reverses when we group observations according to the LYS classification. This is a logical consequence of the fact that the IMF classification does not distinguish between successful and collapsing pegs, and thus includes within the fix group countries that displayed high inflation levels as a result of inconsistent monetary policies that eventually led to a currency crisis. (14)
The table also shows that, as expected, second-round observations correspond to lower inflation rates, indicating that this group captures country observations with relatively less volatility. Within this group, inflation decreases monotonically as we move to regimes with less flexibility.
As mentioned …