April 16, 2002
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Washington, DCDennis Weatherstone Senior Fellow, and former IMF Deputy Research Director, Morris Goldstein recommends that large emerging-market economies adopt "managed floating plus" currency regimes. The "plus" includes inflation targeting to enhance monetary policy discipline and aggressive measures against currency mismatching to limit the risks of financial crises. Such an enhanced system would overcome the "fear of floating" that has deterred many emerging economies from adopting that particular currency strategy and would improve the overall performance of floating exchange rate regimes.
Widespread dissatisfaction with the status quo on currency regimes for emerging economies reflects three developments. First, "soft pegs" and simple "crawls" have displayed high vulnerability to crises in the 1990s. Indeed, almost all the major capital market-related crises since 1994 (Mexico in 1994; Thailand, Indonesia, and South Korea in 1997; Russia and Brazil in 1998; Turkey in 2000 and 2001; and Argentina in 2000 and 2001) have involved a fixed peg or crawling band regime.
Second, while less fragile than soft pegs, the dramatic recent collapse of Argentina's currency board shows that currency boards are neither immune from speculative attack nor do they offer a viable policy instrument to deal with recessions when monetary policy is made abroad, when external debt problems preclude counter-cyclical pump-priming, and when the domestic economy is not flexible enough to correct a real exchange rate overvaluation on its own.
Third, developing countries have exhibited a fear of floating by leaning more heavily (than do industrial-country floaters such as the United States and Japan) on interest rate policy and on exchange market intervention to limit the movement in the nominal exchange rate. When floating is more de jure than de facto, emerging economies do not obtain the benefits associated with greater exchange rate flexibility.
Emerging economies thus appear to be facing a no-win situation. If they opt for soft pegs, the currency regime is likely to eventually blow up in a costly collapse. Alternatively, they can reduce their vulnerability by opting for either a "plain vanilla" floating regime or a hard pegbut then either fear of floating itself or the structural and debt characteristics of their own economies may well deliver disappointing economic performance. Is there another currency regime that would extricate emerging economies from this dilemma?
Goldstein concludes in a new publication that there is such a superior regime. He calls it "managed floating plus" where the "plus" is shorthand for a framework that includes inflation targeting and aggressive measures against currency mismatching. If managed floating were enhanced in this way, it would retain the desirable features of a managed floating rate regime, namely, greater monetary policy independence and resilience to large external shocks. With its plus elements, however, it would also address the nominal anchor and balance-sheet problems that have contributed to a past fear of floating and that have made the track record of plain-vanilla floating less impressive in emerging economies than it could be.
The currency-mismatching problem merits high priority because it is the leading suspect in the large output declines observed in many emerging-market currency crises. In addition, recent empirical work suggests that currency mismatches are the main factor driving a 'fear of floating" (since a large devaluation in the presence of significant dollar-denominated liabilities can mean widespread insolvencies in the banking and/or corporate sectors). The author rejects the view that the only way to deal with currency mismatches is to adopt dollarization. Instead, Goldstein argues that significant progress in reducing currency mismatching can be obtained by:
Goldstein also maintains that good monetary policy discipline is essential to improve the performance of managed floating. Based on experience to date in emerging economies, inflation targeting appears to be a promising monetary policy framework and a better nominal anchor than the leading alternatives (an exchange rate peg or the targeting of monetary aggregates).
The three elements of managed floating should reinforce each other. The more currency mismatching is brought under control, the less should be the fear of floating. If the exchange rate is allowed to move, the greater will be the awareness of currency risk and the incentive to hedge against it. The less necessary it is to regard the exchange rate as a target, the more likely that inflation targeting will be successful (since the monetary authorities will then not have a competing nominal anchor to contend with). The more successful the monetary authorities are in meeting their low inflation targets, the more willing should foreign lenders be to write financial contracts in the borrower's own currency and the more favorable should be the environment for developing local bond markets. And the greater the availability of domestic-currency-denominated financial instruments, the better the prospects for reducing currency mismatching.
Real reform of the international financial architecture will not take place without addressing currency regimes for those emerging economies heavily involved with private capital markets. Adjustable peg and crawling band regimes are too fragile for a world of large and sudden shifts in private capital flows and of occasional slippages in economic policy. Currency boards and dollarization solve some problems but are impotent in dealing with Argentina-type crises characterized by recession, an overvalued real exchange rate, limited flexibility of domestic costs and prices, and too much public debt to permit countercyclical fiscal policy. And plain-vanilla floating has limited appeal to many emerging economies because of their balance-sheet vulnerability to large exchange rate changes and because of their dissatisfaction with monetary targeting as a nominal anchor.
The twenty or so larger emerging economies should therefore choose managed floating plus. It would give them a deterrent to currency mismatching and to balance-sheet vulnerability, a much reduced fear of floating, enough monetary independence to engage in gross tuning of monetary policy to counter recessions, sufficient "flex" in the exchange rate to deal with large shifts of private capital flows, and workable nominal anchor. If not managed floating plus, what will work better?
About the Author
Morris Goldstein, Dennis Weatherstone Senior Fellow since 1994, has held several senior staff positions at the International Monetary Fund (1970-94), including Deputy Director of its Research Department (1987-94). He has written extensively on international economic policy and on international capital markets. He is author, coauthor, or coeditor of numerous Institute books including Assessing Financial Vulnerability: An Early Warning System for Emerging Markets with Graciela Kaminsky and Carmen Reinhart (2000), The Asian Financial Crisis: Causes, Cures, and Systemic Implications (1998), The Case for an International Banking Standard (1997), Private Capital Flows to Emerging Markets after the Mexican Crisis (1996) and The Exchange Rate System and the IMF: A Modest Agenda (1995); and was project director of Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture (1999) for the Council on Foreign Relations Task Force on the International Financial Architecture.
About the Institute
The Institute for International Economics, whose Director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. Its staff of about 50 focus on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and cover all key regions-especially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site. In 2001, it celebrated its twentieth anniversary and moved into its new headquarters at 1750 Massachusetts Avenue, NW. The Institute has recently helped create the Center for Global Development, an independent but closely affiliated institution that will address poverty issues in the developing countries and policies toward them in the United States and other industrial nations.