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8 The global foreign exchange rate system and the ‘Euroization’ of the currency markets† What is the ideal exchange rate system that a country should adopt? The economics literature has identified a number of factors relating to an economy’s structural characteristics, its susceptibility to external shocks, and macroeconomic and institutional conditions that influence the relative desirability of alternative exchange rate regimes. The early literature on the choice of exchange rate regime, which was based on the theory of optimum currency areas, focused on the characteristics that determine whether a country would be better off, in terms of its ability to maintain internal and external balance, with a fixed or a flexible exchange rate arrangement. That literature generally indicated that small open economies, meaning economies where trade represents a large proportion of GNP, are better served by a fixed exchange rate. The less diversified a country’s production and export structure is and the more geographically concentrated its trade, the stronger also is the case for a fixed exchange rate. The attractiveness of a † The contents of this chapter are discussed in more detail in Kettell, B. (2000) What Drives Currency Markets? Financial Times–Prentice Hall. The global foreign exchange rate system and the ‘Euroization’ of the currency markets 175 fixed exchange rate is also greater, the higher the degree of factor mobility is, the less a country’s inflation rate diverges from that of its main trading partners, and the lower the level of economic and financial development is (see Table 8.1). Another approach to the choice of exchange rate regime has focused on the effects of various random disturbances on the domestic economy. The optimal regime in this framework is the one that stabilizes macroeconomic performance, that is, minimizes fluctuations in output, real consumption, the domestic price level, or some other macroeconomic variable. The ranking of fixed and flexible exchange rate regimes depends on the nature and source of the shocks to the economy, policy makers’ preferences (i.e., the type of costs they wish to minimize), and the structural characteristics of the economy. An extension of this approach assumes that the choice of exchange rate regime is not simply one between a perfectly fixed or a freely floating exchange rate. Rather, it is suggested that there is a range of regimes of varying degrees of exchange rate flexibility reflecting different intensities of official intervention in the foreign exchange market. The typical finding is that a fixed exchange rate (or a greater degree of fixity) is generally superior if the disturbances impinging on the economy are predominantly domestic nominal shocks, such as sudden changes in the demand for money. A flexible rate (or a greater degree of flexibility) is preferable if disturbances are predominantly foreign shocks or domestic real shocks, such as shifts in the demand for domestic goods. Credibility versus flexibility A more recent strand of analysis has emphasized the role of credibility and political factors in the choice of exchange rate regime. A point that emerges from this analysis is that when the domestic rate of inflation is extremely high, a pegged exchange rate (by providing a clear and transparent nominal anchor) can help to establish the credibility of a stabilization programme. An exchange rate anchor may also be preferable because of instability in the demand for money as inflation is reduced sharply. This contrasts with the traditional view that the less a country’s inflation rate diverges from that of its main trading partners the more desirable is a fixed exchange rate. In some cases, a fixed exchange rate can help to discipline a country’s economic policies, especially fiscal policy. This is particularly relevant for developing countries that do not have the same capacity as advanced economies to separate fiscal and 176 Economics for Financial Markets monetary policy. A fixed exchange rate constrains the authorities’ use of what is known as the ‘inflation tax’ as a source of revenue, the more so if the exchange rate is rigidly fixed as in a monetary union or a currency board. The idea that inflation is a form of tax is based on the principle that we need to hold more cash when inflation rises. For example, when inflation is 10 per cent per year, a person who holds currency for a year loses 10 per cent of the purchasing power of that money and thus effectively pays a 10 per cent tax on the real money holdings. The beneficiary here being the government as they have purchased goods and services, which was the cause of the inflation in the first place. The advantage of the fixed exchange rate here is that if the commitment not to use the inflation tax implied by the adoption of a rigidly fixed exchange rate is credible, it allows the authorities to tie down private sector expectations of inflation. In contrast, a flexible exchange rate provides the authorities with greater scope for revenue from seigniorage, i.e., the revenue that the government raises by printing money, but at the expense of a lack of precommitment as regards future inflation. An adjustable peg provides the authorities with the option to devalue and tax the private sector by generating unanticipated inflation. The risk here, however, is that the peg may become unsustainable if confidence in the authorities’ willingness, or ability to maintain it, is lost. In this framework, the choice of regime involves a trade-off between ‘credibility’ and ‘flexibility’, and may depend not only on the nature of the economy and the disturbances to which it is subject but also on political considerations. For instance, it may be more costly politically to adjust a pegged exchange rate than to allow the nominal exchange rate to move by a corresponding amount in a more flexible exchange rate arrangement. This is because the former is clearly visible and involves an explicit government decision, while the latter is less of an event and can be attributed to market forces. When the political costs of exchange rate adjustments are high, it is therefore more likely that a more flexible exchange rate arrangement will be adopted, the more so the larger and more frequent the expected adjustment under a pegged regime. Choice of peg: single currency or basket? When the choice of regime has been made in favour of a pegged exchange rate, a further choice arises between pegging to a The global foreign exchange rate system and the ‘Euroization’ of the currency markets 177 single currency and pegging to a basket of currencies. When the peg is to a single currency, fluctuations in the anchor currency imply fluctuations in the effective (trade-weighted) exchange rate of the currency in question. By pegging to a currency basket instead, a country can reduce the vulnerability of its economy to fluctuations in the values of the individual currencies in the basket. Thus, in a world of floating exchange rates among the major currencies, the case for a single currency peg is stronger if the peg is to be the currency of the dominant trading partner. However, in some cases, a significant portion of the country’s debt service may be denominated in other currencies. This may complicate the choice of currency to which to peg. For instance for a number of East Asian countries the United States is the major export market, but debt is often serviced largely in Japanese yen. With their currencies typically pegged to dollar-denominated baskets, movements in the yen– dollar rate in recent years have thus posed difficulties for some of these countries. Macroeconomic characteristics of exchange rate regimes Traditionally a distinction in discussing exchange rate arrangements is to differentiate between ‘pegged’ and ‘flexible’ exchange rate systems. The former comprises arrangements in which the domestic currency is pegged to a single foreign currency or to a basket of currencies, including the Special Drawing Right, discussed below. The latter consists of arrangements in which the exchange rate is officially classified as ‘managed’ or ‘independently floating’. The major difference in economic performance between these two groupings of exchange rate arrangements is with respect to inflation. Inflation in countries with pegged exchange rates has historically been consistently lower and less volatile than in countries with more flexible exchange rate arrangements, but the difference has narrowed substantially in the 1990s. In contrast to the marked difference in inflation performance across regimes, there is no clear relationship between exchange rate regime and output growth over the past two decades as a whole. During the 1990s, however, the median growth rate in countries with flexible exchange rate arrangements appears to have been higher than in countries with pegged exchange rates between the two sets of exchange rate arrangements. 178 Economics for Financial Markets Countries that have officially declared flexible exchange rate regimes are on average larger economies. They are also less open, where openness is measured by the ratio of trade to output, which partly reflects the fact that larger economies tend to be more self-sufficient. These findings accord with the theory of optimal currency areas, which predicts that, all else being equal, the smaller and more open is an economy, the stronger is the case for a fixed exchange rate. So what are the lessons with respect to the choice of an exchange rate regime? In an era when countries are becoming increasingly linked to one another through trade and capital flows, the functioning of a country’s exchange rate regime is a critical factor in economic policy making. At issue is the extent to which a country’s economic performance and the mechanism whereby monetary and fiscal policies affect inflation and growth are dependent on the exchange rate regime. There is no perfect exchange rate system. What is best depends on a particular economy’s characteristics. A useful analysis in the IMF’s May 1997 World Economic Outlook considers some of the factors which affect the choice. These include the following. 䊉 䊉 䊉 䊉 䊉 Size and openness of the economy. If trade is a large share of GDP, then the costs of currency instability can be high. This suggests that small, open economies may be best served by fixed exchange rates. Inflation rate. If a country has much higher inflation than its trading partners, its exchange rate needs to be flexible to prevent its goods from becoming uncompetitive in world markets. If inflation differentials are more modest, a fixed rate is less troublesome. Labour market flexibility. The more rigid wages are, the greater the need for a flexible exchange rate to help the economy to respond to an external shock. Degree of financial development. In developing countries with immature financial markets, a freely floating exchange rate may not be sensible because a small number of foreign exchange trades can cause big swings in currencies. The credibility of policymakers. The weaker the reputation of the central bank, the stronger the case for pegging the exchange rate to build confidence that inflation will be The global foreign exchange rate system and the ‘Euroization’ of the currency markets 䊉 179 controlled. Fixed exchange rates have helped economies in Latin America to reduce inflation. Capital mobility. The more open an economy to international capital, the harder it is to sustain a fixed rate. Table 8.1 summarizes many of these ideas. Dollarization and the choice of an exchange rate regime Dollarization, the holding by residents of a significant share of their assets in foreign currency-denominated form, in this case the US dollar, is a common feature of developing and transition economies. It is a response to economic instability and high inflation, and to the desire of domestic residents to diversify their asset portfolios. In countries experiencing high inflation dollarization is typically quite widespread as the public seeks protection from the cost of holding assets denominated in domestic currency. To best understand the role of dollarization in influencing the choice of exchange rate regime, it is useful to distinguish between two motives for holding foreign currency assets: currency substitution and asset substitution. Currency substitution occurs when assets denominated in foreign currency are used as a means of payment, while asset substitution occurs when assets denominated in foreign currency serve as stores of value. Currency substitution typically arises during high inflation, when the cost of holding domestic currency for transactions purposes is high. Asset substitution results from portfolio allocation decisions and reflects the relative risk and return characteristics of domestic and foreign assets. In many developing countries, assets denominated in foreign currency have often provided residents with the opportunity to insure against major domestic macroeconomic risks. Dollarization introduces additional complications into the choice of exchange rate regime. A key implication of currency substitution is that exchange rates will tend to be more volatile. One reason for this is that there may be frequent and unexpected shifts in the use of domestic and foreign money for transactions, given the ease of switching between domestic money and the dollar. Another is that demand for the domestic currency-denominated component of the money, stock will be 180 Table 8.1 Economics for Financial Markets Considerations in the Choice of Exchange Rate Regime. Characteristics of Economy Implication for the Desired Degree of Exchange Rate Flexibility Size of the economy The larger the economy, the stronger is the case for a flexible rate. Openness The more open the economy, the less attractive is a flexible exchange rate. Diversified production/ export structure The more diversified the economy, the more feasible is a flexible exchange rate. Geographic concentration of trade The larger the proportion of an economy’s trade with one large country, the greater is the incentive to peg to the currency of that country. Divergence of domestic inflation from world inflation The more divergent a country’s inflation rate from that of its main trading partners, the greater is the need for frequent exchange rate adjustments. (But for a country with extremely high inflation, a fixed exchange rate may provide greater policy discipline and credibility to a stabilization programme.) Degree of economic/ financial development The greater the degree of economic and financial development, the more feasible is a flexible exchange rate regime. Labour mobility The greater the degree of labour mobility, when wages and prices are downwardly sticky, the less difficult (and costly) is the adjustment to external shocks with a fixed exchange rate. Capital mobility The higher the degree of capital mobility, the more difficult it is to sustain a pegged-but-adjustable exchange rate regime. Foreign nominal shocks The more prevalent are foreign nominal shocks, the more desirable is a flexible exchange rate. Domestic nominal shocks The more prevalent are domestic nominal shocks, the more attractive is a fixed exchange rate. Real shocks The greater an economy’s susceptibility to real shocks, whether foreign or domestic, the more advantageous is a flexible exchange rate. Credibility of policymakers The lower the anti-inflation credibility of policymakers, the greater is the attractiveness of a fixed exchange rate as a nominal anchor. Source: IMF The global foreign exchange rate system and the ‘Euroization’ of the currency markets 181 more sensitive to changes in its expected opportunity cost. Using the jargon of economics, the interest elasticity of domestic money demand will be higher when there is significant currency substitution, meaning that as domestic and foreign interest rates change investors will switch between assets, with the choices depending on expected returns. In a floating exchange rate regime, this higher elasticity and instability of money demand is likely to result in greater exchange rate volatility. This strengthens the argument for the adoption of a pegged exchange rate when currency substitution is extensive. Nevertheless, the broader considerations, discussed earlier in this chapter, that should guide the choice of exchange rate system, still apply. In particular, if shocks originate mostly in money markets, then fixed exchange rates provide more stability, but if shocks are mostly real in nature, floating rates are superior in stabilizing output. There is a clear case for fixing the exchange rate when a highly dollarized economy is stabilizing from very high inflation or hyperinflation. Under these circumstances currency substitution is likely to be important, and monetary shocks are likely to predominate, especially as successful stabilization may result in a large but unpredictable increase in the demand for domestic currency. Moreover, during hyperinflation, foreign currency may assume the role of a unit of account, and the exchange rate may also serve as an approximate measure of the price level, making it a powerful guide for influencing expectations in the transition to a low inflation equilibrium. Argentina in 1991 is an example of a country where an exchange rate anchor helped to stop hyperinflation in the context of extensive currency substitution. Dollarization in the sense of asset substitution also has implications for the choice of an exchange rate regime. The most important may be that the availability of foreign currency deposits in domestic banks increases capital mobility, as the public can potentially shift between foreign currency deposits held with domestic banks to those abroad, as well as between foreign currency-denominated and domestic currency-denominated deposits held in domestic banks. These various assets are likely to be close substitutes for savers, which strengthens the link between interest rates on dollar deposits at home, international dollar interest rates, and domestic currency interest rates. This would limit the control that the central bank can exert on monetary conditions, such as the level of interest rates on domestic currency. In contrast to the implications of currency 182 Economics for Financial Markets substitution dollarization, in the sense of asset substitution, may thus increase the usefulness of a flexible exchange rate arrangement in enhancing monetary autonomy. Why do currencies face speculative attacks? Krugman’s dilemma Why are currencies repeatedly subject to speculator attacks? In searching for answers to this question Krugman (1998) draws on what he calls his matrix of opinion, which is defined by the different answers to two questions. The first question is whether flexibility of the exchange rate is useful. A country that fixes its exchange rate, in a world in which investors are free to move their money wherever they like, essentially gives up the opportunity to have its own monetary policy. Interest rates must be set at whatever level makes foreign exchange traders willing to keep the currency close to the fixed target rate. A country that allows its exchange rate to float, on the other hand, can reduce interest rates to fight recessions and raise them to fight inflation. So the first question Krugman asks, is whether this extra freedom of policy is useful or is it merely illusory? The second question is whether, having decided to float the currency, one can trust the foreign exchange market not to do anything crazy. Will the market set the currency at a value more or less consistent with the economy’s fundamental strength and the soundness of the government’s policies? Or will the market be subject to alternating bouts of irrational exuberance, to borrow the famous phrase of Federal Reserve Chairman Alan Greenspan, and unjustified pessimism? The answers one might give to these questions define four boxes, all of which have their adherents. The matrix is illustrated in Figure 8.1. Suppose that you believe that the policy freedom a country gains from a floating exchange rate is actually worth very little, but you also trust the foreign exchange market not to do anything silly. Then you will be a very relaxed individual. You will not much care what regime is chosen for the exchange rate. You may have a small preference for a fixed rate or better yet a The global foreign exchange rate system and the ‘Euroization’ of the currency markets 183 Is exchange rate flexibility useful? Can the forex market be trusted? Figure 8.1 No Yes Yes Relaxed guy Serene floater No Determined fixer Nervous wreck Krugman’s matrix. common currency, on the grounds that stable exchange rates reduce the costs of doing business, Krugman suggests, but you will not lose sleep over the choice. Suppose on the other hand that you believe that freedom gained by floating is very valuable, and that financial markets can be trusted. Then you will be, what Krugman calls, a serene floater. You will believe in freeing your currency from the constraints of a specific exchange rate target, in order that you can get on with the business of pursuing full employment. This was the view held by many economists in the late 1960s and early 1970s. You will be equally sure of yourself if you believe the opposite, that foreign exchange markets are deeply unreliable, dominated by those irrational bouts of optimism and pessimism, while the monetary freedom that comes with floating is of little value. You will then be a determined fixer. But what if you believe both that the freedom that comes from floating is valuable and that the markets that will determine your currency’s value under floating are unreliable? Then you will be a nervous wreck, subject to stress-related disorders. You will regard any choice of currency regime as a choice between evils, and will always worry that you have chosen wrongly. So, given this matrix in which quadrant do we find ourselves? Krugman believes that the nervous wrecks have it. Yes, the monetary freedom of a floating rate is valuable. No, the foreign exchange market cannot be trusted. This reasoning starts with the case for floating currencies. The classic case against floating rates is that any attempt to make use of monetary autonomy will quickly backfire. Assume that a country drops its commitment to a fixed exchange rate and uses that freedom to cut interest rates, which in turn would lead to a decline in the value of the currency. Fixed exchange rate defenders would argue that instead of an increase in employment the result would be a surge in inflation, wiping out both any gain in competitiveness vis-à-vis foreign producers and any stimulus to real domestic demand. The evidence of the United Kingdom, which exited the