Chapter

II The Choice of Exchange Rate Regime

Author(s):
Charalambos Christofides, Atish Ghosh, Uma Ramakrishnan, Alun Thomas, Laura Papi, Juan Zalduendo, and Jun Kim
Published Date:
September 2005
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Given the primacy of external adjustment and macroeconomic stability in IMF-supported programs, a natural starting point is the exchange rate regime. In particular, a flexible exchange rate can allow for more of the improvement in the current account balance to take place through expenditure switching rather than by monetary and fiscal restraint alone—though, in some circumstances, this can also be achieved through a discrete devaluation under an existing peg.6 Conversely, when disinflation is a primary objective, the use of the exchange rate as a nominal anchor can help induce policy discipline, engender confidence in the currency, and bring down inflationary expectations and real interest rates. The use of such “exchange-rate-based stabilizations” is not uncontroversial, however (Box 4.1).

This section considers the role of the exchange rate regime in IMF-supported programs—Section III takes up the related but distinct issue of the monetary stance. It first sets the stage by considering the extent to which the exchange rate regime has been used as an explicit tool for achieving program objectives. Next it turns to outcomes, examining three questions: Did use of the exchange rate as a nominal anchor assist in disinflation? Did more flexible exchange rate regimes help achieve external adjustment at a lower cost in terms of output? And did countries with pegged regimes subsequently undergo greater external adjustment as balance sheet mismatches unwound?

Exchange Rate Regimes in IMF-Supported Programs

Table 4.1 reports the distribution of exchange rate regimes in the year prior to (year t–1), and the year of (year t), the approval of the arrangement. PRGF-supported members are split almost equally between pegged and flexible exchange rate regimes, whereas for GRA-supported members a larger proportion (60 percent) had pegged exchange rates.7 Transitions in the year that the IMF arrangement was approved occur in less than 20 percent of cases.8 When regime changes occur, these were frequently toward greater flexibility in nontransition GRA-supported countries (as pegs were abandoned9) or toward less flexible regimes in transition economies (to assist disinflation efforts).

Table 4.1.Macroeconomic Performance Under Alternative Exchange Rate Regimes
Countries That Moved to
Pegged1Flexible1Flexible regimesPegged regimes
t–1tt+1t–1tt+1
Proportion of observations
Full sample54.356.657.445.743.442.68.510.9
GRA-supported nontransition economies62.860.558.137.239.541.916.39.3
PRGF-supported nontransition economies52.150.047.947.950.052.14.24.2
Transition economies47.460.560.552.639.531.65.321.1
Change Between Years t–1 and t+1 for Countries That Switched Regimes to
Average for Countries That Did Not Switch Regimes2Flexible regimesPegged regimes
Inflation (in percent a year)3
Full sample12.18.46.619.915.312.21.7–27.5
GRA-supported nontransition economies7.16.95.514.814.713.51.11.8
PRGF-supported nontransition economies8.06.35.410.310.09.5–8.4–9.6
Transition economies24.113.39.742.525.716.013.9–42.9
Real GDP growth (in percent a year)
Full sample3.23.53.12.23.34.3–0.43.9
GRA-supported nontransition economies3.23.92.51.51.33.3–1.0–3.6
PRGF-supported nontransition economies5.14.23.44.93.84.02.0–0.1
Transition economies0.42.13.5–2.04.55.7–0.96.8
Sources: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) and World Economic Outlook; and IMF staff calculations.

Exchange rate regimes as classified by the AREAER. “Pegged regimes” include exchange arrangements with no separate legal tender, currency boards, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independently floating regimes.

Classified by regime prevailing in year of program approval (t).

To reduce the influence of outliers, the inflation rate is mapped into the interval (–100, 100) percent.

Sources: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) and World Economic Outlook; and IMF staff calculations.

Exchange rate regimes as classified by the AREAER. “Pegged regimes” include exchange arrangements with no separate legal tender, currency boards, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independently floating regimes.

Classified by regime prevailing in year of program approval (t).

To reduce the influence of outliers, the inflation rate is mapped into the interval (–100, 100) percent.

To examine the determinants of regime choice in IMF-supported programs, Table 4.2 reports the results of estimating an ordered probit, where a higher score on the regime index indicates a more flexible regime. This analysis shows a great deal of persistence in regime choice—that is, consistent with the observation above, the exchange rate regime is seldom changed as part of an IMF-supported program. The exchange rate regime (whether or not it is changed at the time of program approval) can be explained by various explanatory variables for nontransition country programs. Specifically, in GRA-supported nontransition programs, a pegged (or less flexible) regime is more likely the larger the programmed decline in inflation. Moreover, though the programmed change in the current account balance is not statistically significant, a flexible regime is more likely the greater the estimated overvaluation of the real exchange rate. Other significant determinants are foreign exchange reserves (a higher level of reserves makes a peg more likely) and the output gap (a smaller gap makes a peg more likely). Overall, the probit explains 90 percent of the observations correctly. By contrast, in a similar analysis for PRGF-supported nontransition countries, only the lagged regime variable has the correct sign and is statistically significant—suggesting greater inertia in the choice of exchange rate regime for these countries.10 For transition economies, the fit of the equation is much worse, and only the lagged regime and the estimated degree of overvaluation are statistically significant.

Table 4.2.Choice of Exchange Rate Regime: Results of Ordered Probit1, 2
Dependent Variable: Exchange Rate Regime in Year of Program Approval (t)
Nontransition GRANontransition PRGFTransition
Explanatory variables
Exchange rate regime in year t–13.56***1.21***0.81***
Programmed change in inflation0.31**0.00–0.01
Programmed change in the current account balance–0.220.010.06
Output gap at t–130.30**–0.01–0.01
Deviation of the real exchange rate from a long-term trend at t–140.22***0.010.06***
Level of reserves in months of imports at t–1–0.15*–0.080.15
Dummy for CFA countries–1.33
Pseudo-R20.740.670.32
No. of observations414236
Observations correctly predicted (in percent)909044
Sources: IMF, AREAER, International Financial Statistics, and Information Notice System, MONA, and WEO databases; and IMF staff estimates.

A higher score indicates more flexible regimes on the eight-category scale of the AREAER. The categories are (1) no separate legal tender; (2) currency boards; (3) other conventional pegs; (4) pegged arrangements with horizontal bands; (5) crawling pegs; (6) crawling bands; (7) managed floats; and (8) independent floats.

Significant at: *** 1 percent, ** 5 percent, and * 10 percent levels.

Positive value indicates output below trend. Trend GDP is obtained from a Hodrick-Prescott filter.

Positive value indicates overvaluation. The trend real exchange rate is obtained from a Hodrick-Prescott filter.

Sources: IMF, AREAER, International Financial Statistics, and Information Notice System, MONA, and WEO databases; and IMF staff estimates.

A higher score indicates more flexible regimes on the eight-category scale of the AREAER. The categories are (1) no separate legal tender; (2) currency boards; (3) other conventional pegs; (4) pegged arrangements with horizontal bands; (5) crawling pegs; (6) crawling bands; (7) managed floats; and (8) independent floats.

Significant at: *** 1 percent, ** 5 percent, and * 10 percent levels.

Positive value indicates output below trend. Trend GDP is obtained from a Hodrick-Prescott filter.

Positive value indicates overvaluation. The trend real exchange rate is obtained from a Hodrick-Prescott filter.

Box 4.1.Exchange-Rate-Based Stabilizations

Exchange-rate-based stabilizations (ERBS) are often advocated for countries starting from high and chronic inflation because the nominal exchange rate provides a highly visible anchor for private sector expectations. In particular, in countries with high dollarization and a high pass-through from the exchange rate to prices, the exchange rate can stabilize and coordinate expectations quickly, and may promote policy discipline.1 An exchange rate anchor could also be attractive to countries with high real interest rates, as an ERBS might reduce them more rapidly than a money-based-stabilization (MBS). Another benefit could be the relative ease of conducting monetary policy, in contrast to MBS, where the appropriate rate of money growth must be determined, often in situations of highly unstable money demand. The transparency of ERBS may also enhance the credibility of the monetary authorities, thus reducing the costs of disinflation.

However, the debate on ERBS is still open. Some authors maintain that the costs of disinflations carried out with an exchange rate anchor are merely postponed. They point to some empirical regularities observed in ERBS (the so-called ERBS syndrome), namely a substantial real exchange rate appreciation and related deterioration in the external accounts, which often leads to a balance of payments crisis, and a boom-bust cycle in GDP, consumption, and investment.2 ERBS have been linked to financial crises as well.3 The ability of a predetermined exchange rate regime to impose discipline on other policies, notably fiscal policy, is also disputed.4 In addition, overvaluation under a pegged exchange rate regime may mask temporarily the extent of public indebtedness.

But other authors challenge empirical regularities that characterize the ERBS syndrome. For example, some authors do not find evidence that output dynamics differ based on the anchor used in the stabilization. Others find expansionary effects on output of ERBS from high inflation.5 Similarly, the claim that ERBS have a higher percentage of failures has been questioned (see Tables A and B).6 In fact, these differences in findings may reflect the small samples used in some studies: for example, Calvo and Végh (1999) examined 5 episodes of MBS compared to 12 ERBS. However, in studies where a large number of episodes are studied (typically identified by rules), the evidence of the ERBS syndrome is much weaker, if extant at all.7

Table A.Successful Stabilization Episodes
Successful1
EpisodesCriterion 1Criterion 2
Total number of episodes512034
Of which successful stabilizations (in percent)3967
Exchange-rate-based stabilizations1359
Of which successful stabilizations (in percent)3869
Source: Hamann (2001).

Criterion 1 defines success as inflation at t+2 and t+3 is no higher than during stabilization year. Criterion 2 defines success as inflation at t+2 and t+3 is no higher than three-fourths of the inflation rate prevailing the year before stabilization.

Source: Hamann (2001).

Criterion 1 defines success as inflation at t+2 and t+3 is no higher than during stabilization year. Criterion 2 defines success as inflation at t+2 and t+3 is no higher than three-fourths of the inflation rate prevailing the year before stabilization.

Table B.Disinflation Attempts Under Alternative Exchange Rate Regimes(Initial inflation above 50 percent a year, at least 20 percentage point decline)
PeggedIntermediateFloat
Proportion of cases with inflation below post-disinflation level in:
Year t+153.141.051.4
Year t+243.835.940.0
Year t+343.825.628.6
Source: Ghosh, Gulde, and Wolf (2003).
Source: Ghosh, Gulde, and Wolf (2003).

Schadler and others (1995) in the 1994 Conditionality Review studied 16 countries (out of a total sample of 36) that adopted a monetary anchor—defined as either a money supply rule (1 country) or a predetermined exchange rate path (15 countries). They concluded that, while there is no substitute for tight financial policies and wage restraint, exchange rate anchors appeared to have sped up disinflation and helped keep inflation low. At the same time, they pointed to significant costs in terms of competitiveness, export growth, and possibly short-term output growth associated with the disinflation gains. Finally, they viewed the adoption of some nominal anchor as indispensable in reducing high or intermediate inflation, but underscored the key role of supporting policies.

Finally, when the exchange rate regime chosen for disinflation differs from the regime considered more suitable for the country from a longer-run perspective, issues of exit arise. For example, as discussed in Lessons from the Crisis in Argentina (Daseking and others, 2004), the currency board arrangement adopted by Argentina in 1991 was instrumental in bringing down inflation after decades of high inflation, but given extensive dollarization of the economy and turbulence in international capital markets, it was difficult to find an opportunity to exit the regime gracefully even as it became apparent that a lack of competitiveness was impeding growth and that fiscal policy necessary to sustain the peg was not forthcoming. The IMF-supported program in Turkey (1999) preannounced an explicit exit strategy (and timetable) for exiting the quasi-currency board arrangement adopted at the outset of the stabilization program. The preannouncement does not appear to have undermined credibility of the regime, though in the event it collapsed for other reasons prior to the planned exit date.

1See Calvo and Végh (1999) and Hamann (2001) for surveys of the literature on ERBS.2See for example Kiguel and Liviatan (1992), Végh (1992), and Calvo and Végh (1994).3See Sobolev (2000).4Hamann (2001) does not find evidence of increased fiscal discipline of ERBS.5Fischer, Sahay, and Végh (2002).6See Easterly (1996); Ghosh, Gulde, and Wolf (2002); Hamann (2001); Hamann and Prati (2002); and Santaella and Vela (1996).7Fischer, Sahay, and Végh (2002) and Hamann (2001).

Experience

A number of findings can be highlighted in terms of macroeconomic performance and exchange rate regime, though of course the regime choice may itself be endogenous to macroeconomic performance.11 Inflation for the full sample is lower under pegged exchange rates and inflation declines rapidly over the program period under both pegged and flexible regimes, though remaining higher in countries with flexible regimes (see Table 4.1). The evidence on growth is less clear. Pegged regimes experienced modest variations in real growth while countries with flexible regimes saw an acceleration in real growth. For countries that switched regimes, pegging the exchange rate is associated with better inflation performance, though the sample of such countries is small and the results mostly driven by the experience of the transition economies. The growth experience of countries switching regimes is mixed: transition economies saw a sharp acceleration in growth under their exchange rate pegs (albeit after an initial collapse in output and a sharp depreciation of the real exchange rate), while non-transition economies that switched to flexible regimes fared better than those that switched to pegged regimes.

Disinflation Attempts

Most GRA-supported programs that started from high (above 20 percent a year) inflation rates and that targeted substantial disinflation used an exchange rate anchor. In 80 percent of the cases, the target was achieved, and in two-thirds inflation remained low up to three years later (Table 4.3 and Figure 4.1). For GRA-supported programs starting with relatively low inflation rates, about half of the disinflation attempts were based on flexible regimes and these programs had higher rates of success than similar disinflations under pegged regimes. In PRGF-supported programs, by contrast, disinflation attempts starting from high inflation did not use the exchange rate as a nominal anchor. Success rates have been similar to GRA-supported programs: in about 80 percent of cases the initial disinflation was achieved, and in three-quarters inflation remained low up to three years later (Table 4.3, Figure 4.2).

Table 4.3.Success Rates for Disinflation Attempts Under Alternative Exchange Rate Regimes
AllNontransitionTransition
Pegged1Flexible1Pegged1Flexible1Pegged1Flexible1
I. GRA-supported programs
1. Low-inflation countries2544311
Success3131201
Of which: Success II4030201
Failure413110
2. Moderate-inflation countries51215170
Success3813150
Of which: Success II4713140
Failure402020
3. High-inflation countries6921181
Success3921181
Of which: Success II4710071
Failure000000
II. PRGF-supported programs
1. Low-inflation countries2898702
Success3535201
Of which: Success II4313100
Failure363501
2. Moderate-inflation countries5080503
Success3060303
Of which: Success II4050203
Failure020200
3. High-inflation countries6040202
Success3040202
Of which: Success II4040202
Failure000000
Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

Exchange rate regime at t+1.

Low-inflation cases refer to end-of-period inflation of less than 20 percent and programmed change in inflation between t–1 and t+1 of less than –5 percent.

Success is defined as actual disinflation performance at least meeting the programmed disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Success II refers to the cases within Success in which disinflation is maintained, as measured by the difference between the average of end-period inflation in t+2 and t+3 and inflation in t–1 at least meeting the programmed disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Moderate-inflation cases refer to end-of-period inflation between 20 percent and 50 percent and programmed change in inflation between t–1 and t+1 of less than –10 percent.

High-inflation cases refer to end-of-period inflation greater than 50 percent and programmed change in inflation between t–1 and t+1 of less than –20 percent.

Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

Exchange rate regime at t+1.

Low-inflation cases refer to end-of-period inflation of less than 20 percent and programmed change in inflation between t–1 and t+1 of less than –5 percent.

Success is defined as actual disinflation performance at least meeting the programmed disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Success II refers to the cases within Success in which disinflation is maintained, as measured by the difference between the average of end-period inflation in t+2 and t+3 and inflation in t–1 at least meeting the programmed disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Moderate-inflation cases refer to end-of-period inflation between 20 percent and 50 percent and programmed change in inflation between t–1 and t+1 of less than –10 percent.

High-inflation cases refer to end-of-period inflation greater than 50 percent and programmed change in inflation between t–1 and t+1 of less than –20 percent.

Figure 4.1.Inflation and Growth in GRA-Supported Programs Under Alternative Disinflation Strategies1, 2, 3

(In percent; 1995–2000)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

1Inflation rates are transformed to be mapped into the interval (–100,100) percent.

2Exchange rate regime at t+1.

3Definitions of low-, moderate-, and high-inflation are given in Table 4.3.

Figure 4.2.Inflation and Growth in PRGF-Supported Programs Under Alternative Disinflation Strategies1, 2, 3

(In percent; 1995–2000)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

1Inflation rates are transformed to be mapped into the interval (–100,100) percent.

2Exchange rate regime at t+1.

3Definitions of low-, moderate-, and high-inflation are given in Table 4.3.

While individual country circumstances—for instance, initial credibility of newly (re)established central banks in transition economies—may suggest a particular (exchange-rate-based versus money-based) disinflation strategy, the contrasting findings for disinflation attempts under GRA- and PRGF-supported programs do not allow for unequivocal conclusions about which strategy is more likely to succeed. Rather, a distinguishing feature between successful and failed stabilization efforts appears to be whether supporting policies were in place. Although the proximate reason that inflation targets are missed and disinflation attempts fail is often monetary overruns—as discussed in Section III—it is also worth considering some of the underlying causes of failures. To this end, Table 4.4 correlates success at disinflations—under both pegged and more flexible regimes—to fiscal performance under the IMF-supported program. From the table, fiscal slippage is significantly greater in cases where disinflation was unsuccessful. Indeed, whereas the fiscal balance was marginally better than programmed in cases that succeeded in disinflation, it fell short by 2.3 percent of GDP in cases that failed—a difference that is statistically significant. Countries that succeeded in achieving and maintaining low inflation also managed to achieve their fiscal targets, compared to a fiscal slippage of 1.5 percent of GDP among those programs that failed to maintain low inflation.

Table 4.4.Fiscal Adjustment and Success Rates for Disinflation Attempts
Projection Error: Actual – Projected1
Full sampleGRA-supportedPRGF-supported
Fiscal balance2Inflation2Fiscal balance2Inflation2Fiscal balance2Inflation2
1. Disinflation attempts3–0.834.42–0.755.98–0.912.76
(Number of observations)585830302828
Success40.050.310.122.01–0.03–1.60
(Number of observations)363619191717
Of which:
Success II50.100.800.392.14–0.34–1.20
(Number of observations)303018181212
Failure II–1.46–4.02–4.81–0.250.22–5.91
Failure–2.2611.16–2.2612.82–2.269.49
(Number of observations)222211111111
2. Nondisinflation programs–0.500.62–0.881.04–0.090.16
(Number of observations)545428282626
3. Failure + Nondisinflation–1.013.67–1.274.37–0.732.94
(Number of observations)767639393737
t-statistics for:6
H0: Success = Failure3.62***–4.02***2.13*–2.39**3.37***–3.71***
H0: Success II = Failure II0.921.72–1.601.40
Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Average of projection errors for years t and t +1.

Fiscal balance refers to the change in fiscal balance in percent of actual GDP; inflation is end of period, in percent a year.

Disinflation attempts refer to programs that envisaged disinflation between years t–1 and t+1 of (1) over 5 percent when initial inflation in t–1 is less than 20 percent, or; (2) over 10 percent, when initial inflation is between 20 percent and 50 percent, or (3) over 20 percent, when initial inflation is higher than 50 percent.

Success is defined as actual disinflation performance between years t–1 and t+1 at least meeting the disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Success II refers to the cases within Success in which disinflation is maintained, as measured by the difference between average inflation for t+2 and t+3 and inflation at t–1 at least meeting the disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Two-sided t-test for differences in mean. Significant at 10 percent *, 5 percent **, and 1 percent *** levels.

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Average of projection errors for years t and t +1.

Fiscal balance refers to the change in fiscal balance in percent of actual GDP; inflation is end of period, in percent a year.

Disinflation attempts refer to programs that envisaged disinflation between years t–1 and t+1 of (1) over 5 percent when initial inflation in t–1 is less than 20 percent, or; (2) over 10 percent, when initial inflation is between 20 percent and 50 percent, or (3) over 20 percent, when initial inflation is higher than 50 percent.

Success is defined as actual disinflation performance between years t–1 and t+1 at least meeting the disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Success II refers to the cases within Success in which disinflation is maintained, as measured by the difference between average inflation for t+2 and t+3 and inflation at t–1 at least meeting the disinflation target (i.e., 5 percent, 10 percent, and 20 percent).

Two-sided t-test for differences in mean. Significant at 10 percent *, 5 percent **, and 1 percent *** levels.

When the exchange rate is not pegged, the country needs some other monetary framework to conduct monetary policy (Box 4.2). In IMF-supported programs, countries with no exchange rate peg, used either a monetary target, or an inflation target, or had no explicit nominal anchor.12 Countries with monetary targeting aimed at more ambitious disinflations and achieved greater reductions in inflation than countries that had no explicit nominal anchor (Table 4.5).13 Even in those cases where the projected decline in inflation was smaller under monetary targeting than in countries without an explicit nominal anchor (GRA-supported programs in nontransition economies and PRGF-supported programs in transition economies), the actual decline in inflation was greater under monetary targeting. Only two countries in the sample had an inflation-targeting framework in the year the arrangement was approved. These countries sought to maintain inflation at about 5 percent; in the event, inflation turned out to be 6¼ percent a year.

Table 4.5.Inflation Performance Under Alternative Monetary Regimes1, 2
Number of Countries in Year tInflation in Year t–1Change in Inflation Between Year t–1 and Year t+1
ActualProgrammedActual
(Percent)(Percentage points)
Full sample4117.3–11.3–7.9
Of which for programs with
Inflation targeting25.0–0.31.3
Monetary targeting1120.6–14.8–11.4
No explicit nominal anchor32816.9–10.8–7.2
GRA-supported nontransition economies118.1–3.0–0.7
Of which for programs with
Inflation targeting25.0–0.31.3
Monetary targeting35.6–2.4–2.7
No explicit nominal anchor3610.3–4.2–0.3
PRGF-supported nontransition economies199.5–5.2–3.2
Of which for programs with
Inflation targeting0
Monetary targeting613.8–9.0–5.2
No explicit nominal anchor3137.5–3.4–2.2
Transition economies1140.0–30.4–23.4
GRA-supported transition economies450.1–39.2–24.9
Of which for programs with
Inflation targeting0
Monetary targeting195.7–82.6–61.2
No explicit nominal anchor3334.9–24.7–12.8
PRGF-supported transition economies734.1–25.3–22.5
Of which for programs with
Inflation targeting0
Monetary targeting130.8–19.3–25.2
No explicit nominal anchor3634.7–26.3–22.1
Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

The monetary regime classification is based on the regime prevailing in year of program approval (t). The sample used for this exercise is smaller than in the rest of the paper due to data availability. Only the last arrangement of each country is considered.

Inflation is end of period. To reduce the influence of outliers, the inflation rate was transformed to be mapped into the interval (–100,100) percent.

No explicit nominal anchor was in place, except—in most cases—for a ceiling on net domestic assets (NDA) of the central bank and a floor on net international reserves (NIR) under the IMF-supported program.

Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

The monetary regime classification is based on the regime prevailing in year of program approval (t). The sample used for this exercise is smaller than in the rest of the paper due to data availability. Only the last arrangement of each country is considered.

Inflation is end of period. To reduce the influence of outliers, the inflation rate was transformed to be mapped into the interval (–100,100) percent.

No explicit nominal anchor was in place, except—in most cases—for a ceiling on net domestic assets (NDA) of the central bank and a floor on net international reserves (NIR) under the IMF-supported program.

External Adjustment

Besides the inflation objective, the exchange rate regime may be important for external adjustment. Flexible exchange rate regimes should allow for more of the adjustment to take place through expenditure switching rather than by demand restraint alone, implying a smaller output cost of a given improvement in the current account balance. To examine this hypothesis, the change in real GDP growth (between years t–1 and t+1) is regressed on the change in the current account balance, where the latter is instrumented by the projected change (Table 4.6). A given improvement in the current account balance is associated with lower output growth under fixed exchange rate regimes (significantly so for GRA-supported programs in nontransition economies14), but the corresponding coefficient under floating regimes is not significantly different from zero. The hypothesis of equality of coefficients under fixed and flexible regimes is strongly rejected, suggesting that, for these countries, more flexible regimes facilitated external adjustment.

Table 4.6.External Adjustment and Growth Under Alternative Exchange Rate Regimes: Regression Results1
Nontransition GRA-Supported
Dependent Variable: Change in Output Growth2All programsAllExcluding capital account crisesNontransition PRGF-SupportedTransition Economies
I. Fixed exchange rate regime3
Constant0.4270.6860.423–1.7803.732**
Change in terms of trade growth20.065*0.122*0.117*0.0110.085
Change in current account balance2, 4–0.686***–0.860**–0.879**–0.361–0.181
R20.1540.3070.3630.0450.035
Number of observations7126242421
II. Flexible exchange rate regime3
Constant1.899**0.9501.358–0.4634.558**
Change in terms of trade growth20.0860.136*0.172**–0.0330.267***
Change in current account balance2, 4–0.1340.3750.5070.480–0.490
R20.0810.2990.4800.0570.406
Number of observations5315112315
t-statistics for equality:5
Constant1.439*0.1890.5761.0890.441
Change in current account balance1.643*2.747***2.763***1.201–0.738
Sources: IMF, MONA and WEO databases; and IMF staff estimates.

* significant at 10 percent, ** significant at 5 percent, and *** significant at 1 percent levels.

Changes between year t–1 and t+1; the current account balance (net of official transfers) is in percent of GDP at t–1; all regressors except for the constant term were transformed to be mapped into an interval (–100,100) percent to reduce the influence of outliers.

Exchange rate regimes are classified by AREAER; “fixed regimes” include no separate legal tender, currency board arrangement, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independent floats.

Instrumented by programmed change in the current account balance and the change in actual growth of the terms of trade.

t-statistics for the hypothesis of equality of coefficients between fixed and flexible regime.

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

* significant at 10 percent, ** significant at 5 percent, and *** significant at 1 percent levels.

Changes between year t–1 and t+1; the current account balance (net of official transfers) is in percent of GDP at t–1; all regressors except for the constant term were transformed to be mapped into an interval (–100,100) percent to reduce the influence of outliers.

Exchange rate regimes are classified by AREAER; “fixed regimes” include no separate legal tender, currency board arrangement, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independent floats.

Instrumented by programmed change in the current account balance and the change in actual growth of the terms of trade.

t-statistics for the hypothesis of equality of coefficients between fixed and flexible regime.

A second hypothesis regarding the relationship between the exchange rate regime and external adjustment is that countries with pegged regimes are more susceptible to capital account shocks because the exchange rate guarantee implicit in the peg encourages unhedged foreign-currency-denominated borrowing by the private sector.15 Although a number of capital account crisis countries had de jure or de facto pegs prior to the crisis and much larger capital outflows than projected at the time the arrangement was approved, this does not hold more generally. In fact, countries with more flexible regimes were more likely subsequently to undergo greater external adjustment than programmed (Table 4.7).16

Table 4.7.Exchange Rate Regime and External Adjustment1
Year t–1Year t
Pegged2Flexible2Pegged2Flexible2
GRA-supported nontransition economies25182617
Of which proportion with current account balance (in percent)
Above programmed current account balance32.077.8**34.676.5**
Above debt-stabilizing balance and initial debt below 40 percent of GDP24.05.619.211.8
GRA-supported transition economies1713237
Of which proportion with current account balance (in percent)
Above programmed current account balance5.930.813.028.6
Above debt-stabilizing balance and initial debt below 40 percent of GDP35.315.426.128.6
Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

The difference in proportions under pegged and flexible regimes is tested. Significant at the 1 percent ***, 5 percent **, and 10 percent * levels.

Exchange rate regimes as classified by AREAER; “pegged regimes” include exchange arrangements with no separate legal tender, currency boards, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independent floats.

Sources: IMF, AREAER and MONA and WEO databases; and IMF staff estimates.

The difference in proportions under pegged and flexible regimes is tested. Significant at the 1 percent ***, 5 percent **, and 10 percent * levels.

Exchange rate regimes as classified by AREAER; “pegged regimes” include exchange arrangements with no separate legal tender, currency boards, other conventional pegs, pegs with horizontal bands, crawling pegs, and crawling bands; “flexible regimes” include managed and independent floats.

Box 4.2.Monetary Regimes When the Exchange Rate Is Not Pegged

When the country does not peg its exchange rate (thereby subordinating its monetary policy to maintaining the peg), it must have some other nominal anchor and monetary regime. Of countries without pegged regimes in the year of program approval, other monetary frameworks prevailed in 70 percent of the cases. In most cases, only a ceiling on net domestic assets (NDA) and a floor on net international reserves (NIR) were specified in a program context.1 A further 27 percent targeted monetary aggregates (e.g., reserve, base money, or a broader monetary aggregate such as M2), and only 4 percent had an inflation-targeting framework.

Countries that had only an NDA ceiling and an NIR floor as part of the program conditionality and no explicit monetary framework, arguably lacked a nominal anchor as the NDA/NIR configuration in IMF-supported programs is intended primarily to monitor progress toward external viability and safeguard IMF resources—not to act as a nominal anchor for inflation expectations or monetary policy.2

Predictable money demand is required for aggregates to serve as a useful nominal anchor. Partly because of unstable money demand functions, central banks in several emerging market countries have shifted to inflation targeting. Indeed, in the sample, inflation targeting became more prevalent subsequent to the year in which the arrangement was approved, with several emerging market countries adopting inflation targeting within three years of the approval of the IMF arrangement. In part, this may be because inflation targeting needs institutional and technical requirements—such as central bank operational autonomy, effective monetary policy instruments, a system of accountability for the central bank, and reliable models to forecast inflation and the impact of monetary policy actions on inflation—to make it an effective monetary framework.3 Some countries adopted inflation targeting “lite” before formally adopting this framework.4 (In some programs, some of the changes required to establish a formal inflation-targeting framework are part of the measures included under the program). The time pattern of adopting inflation-targeting frameworks suggests that such frameworks have been considered useful for reducing inflation from moderate or relatively low levels, rather than disinflating from high inflation (see figure).

No PRGF-supported country in the sample adopted inflation targeting.

End-Period Inflation in Inflation-Targeting Countries, 1995–20001

(In percent a year)

Sources: IMF, WEO database; and IMF staff estimates.

1Inflation rates are transformed to be mapped into the interval (–100,100) percent.

1Due to data availability, these statistics on nominal anchors are based on a smaller sample (78 arrangements) compared to the sample used in the rest of the paper: only the most recent arrangement for each country is considered in the same 1995–2000 period. The monetary regimes are classified following the IMF’s AREAER into five categories: (1) exchange rate anchor; (2) monetary aggregate target; (3) inflation-targeting framework; (4) IMF-supported or other monetary program; and (5) other.2The IMF’s focus on NDA originated from the Polak model with a fixed exchange rate regime, where the overall money supply is endogenous and only its composition is under the authorities’ control. Even under a flexible exchange rate arrangement, limits on NDA can: (1) prevent sterilized intervention in the presence of capital outflows; (2) allow an accommodation of money growth if capital outflows are quickly reversed; and (3) act as a disciplining device on fiscal policy. However, NDA limits do not control the overall monetary expansion when the latter is generated by foreign inflows, and hence may not provide a nominal anchor.3Truman (2003) and Schaechter, Stone, and Zelmer (2000).4See Stone (2003).

Summary

Empirically, countries are no more likely to alter their exchange rate regime at the outset of an IMF-supported program than otherwise. Successful disinflations have been undertaken both under pegged and under flexible exchange rate regimes, suggesting that the consistency of macroeconomic policies, and the fiscal adjustment achieved, may be of greater importance than the choice of the nominal anchor. At the same time, some nominal anchor seems needed for disinflation. The exchange rate regime also has implications for external adjustment—in some cases, countries with more flexible regimes achieved a given improvement in the current account at a lower output cost.

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