III Experience with Pegged Rates
- Barry Eichengreen, Inci Ötker, A. Hamann, Esteban Jadresic, R. Johnston, Hugh Bredenkamp, and Paul Masson
- Published Date:
- August 1998
The trend toward greater exchange rate flexibility for developing and transition countries is a prominent theme in the recent evolution of the international monetary system. As detailed in International Monetary Fund (1997), there has been a marked shift away from single-currency pegs since the early 1980s, as described by the official classification that distinguishes between pegged rates, limited flexibility, and more flexible arrangements. In 1975, 87 percent of developing countries had some type of pegged exchange rate, while only 10 percent had flexible rates (the remaining 3 percent being accounted for by the “limited flexibility” category); by 1985. the proportions were 71 percent and 25 percent, respectively; and by 1996, the proportions were 45 percent and 52 percent. It is noteworthy, however, that a number of countries that officially report their exchange rate as “flexible” have exhibited remarkable exchange rate stability against the U.S. dollar, including a number of Southeast Asian currencies prior to the recent crisis in the region. Thus, the movement to de facto exchange rate flexibility is somewhat less than the movement de jure.
To be sure, pegged exchange rate regimes have not disappeared for developing and transition countries. Single currency pegs are operated by countries such as Argentina, Bulgaria, and Estonia, which use them as a bulwark against inflation; by small open economies in the Caribbean and the Pacific, for which trade and tourism with industrial countries are particularly important; by Hong Kong Special Administrative Region (SAR), whose merchandise and financial sectors are exceptionally open to international transactions; and by the members of the Central and West African Monetary Unions, which depend heavily on France for trade and official assistance and peg to the French franc.4
While a number of these pegs are long lived (the members of the two Francophone African monetary unions have been pegging to the French franc for about 50 years, for most of that period without any significant change in the bilateral rate), they are exceptions, not the rule. Most pegs of developing country currencies are short lived. Klein and Marion (1994) analyze 87 episodes of pegged regimes among Latin American and Caribbean countries for the period 1957–90 and find that the mean duration of a peg was about 10 months.5 They also found that one-third of the pegs had been abandoned by the seventh month and more than half were abandoned by the end of the first year. Exit from currency pegs is anything but an infrequent event, heightening the need for contingency planning.
What are the characteristics of the typical exit from a currency peg? As documented in Appendix II, countries that have exited from pegged rates have generally waited to do so until their currency was under pressure. Reserves were already declining (relative to those of other, comparable countries). Output and export growth had already slowed. And if the setting was less than propitious, the aftermath was less than smooth. Real and nominal exchange rate volatility typically increased for an extended period after the exit, and there was a sharp fall in the value of the currency. Output remained depressed for an extended period. This was not the experience of every country, but it was the average experience.
Often, exit from a pegged-rate arrangement is involuntary, the result of a speculative attack. Recent literature and experience have gone a long way toward identifying factors that increase the probability of this event.6 In addition to drawing on the secondary literature and the cross-country evidence of Appendix II, the discussion that follows builds on five country cases—those of Chile, Israel, Mexico, Poland, and Thailand—reviewed in Appendix III. Chile, Israel, and Poland have successfully moved to greater flexibility in the context mainly of upward pressures on the value of their currencies. While exchange rate appreciation had unwanted effects on exports, the move to flexibility occurred in noncrisis situations that did not damage policy credibility or lead to major economic disruption. In contrast, Mexico and Thailand experienced major financial disruptions and loss of policy credibility when forced to abandon currency pegs (or bands). Figure 1 summarizes the exchange rate experience in these five countries.
Figure 1.Evolution of Exchange Rates for the Selected Country Cases
Sources: IMF staff calculations for Chile. Israel, and Poland; Ocker and Pazarbastoflu (1996). and International Monetary Fund, international Financial Statistics for Mexico; and International Monetary Fund International Financial Slatistics for Thailand.
1Average National Bank of Poland rate before May 16, 1995, and fixing rate thereafter.
2As of March 6 1995, the National Bank of Poland increased the spread in Its transactions with banks from ±0.5 percent to ±2 percent around the central rate.
3From end-1984, the Thai baht was fixed against a basket of undisclosed currencies for which official data have not been made available. The U.S. dollar, however, is believed to have the largest share in this basket.
Speculative attacks tend to occur after periods of expansionary monetary policies that lead to high inflation, overvaluation, and large external imbalances. Expansionary policies and overvaluation encourage imports and limit exports. While it may be possible for a time to finance the current account deficits that result through foreign capital inflows and the use of international reserves, these sources of finance will be depleted over time. Typically the end comes abruptly, as the direction of international capital flows reverses and currency traders, anticipating the need for a downward adjustment in the exchange rate, sell the domestic currency short and exhaust the authorities’ remaining reserves in one fell swoop. These patterns are interpretable in terms of “first-generation models” of currency crises in which monetary expansion leads first to the progressive depletion of official reserves and then to their final exhaustion in a dramatic speculative attack.7
In addition, there is evidence that speculative crises are associated with high unemployment, weak banking systems, and high ratios of public debt to GNP. These facts are interpretable in terms of “second-generation models,” in which speculative attacks occur not when official reserves fall to some danger point but rather when domestic conditions arc such that it becomes too costly for the authorities to pursue the policies necessary to defend the exchange rate peg.8 When unemployment is high or growth is slow, the costs of raising interest rates and risking further declines in investment and consumption may be perceived as prohibitive. When the banking system is weak, interest rate hikes threaten to push banks and borrowers into insolvency. When the public debt burden is heavy, the higher interest rates needed to defend the currency may so increase the costs of debt service as to be unsustainable.9
What can limit the incidence of currency crises and increase the durability of currency pegs? The obvious answer is coherent economic policies. Prudent monetary policies will help to limit domestic inflation, overvaluation, and losses of competitiveness. In contrast, use of monetary independence to pursue other objectives—for instance, to stimulate economic activity at a time of high inflation—plants doubts about the commitment of the authorities to an exchange rate peg. The authorities need to make a clear choice between competing objectives. They should undertake potentially costly commitments to defend the exchange rate only if the objective of currency stability unambiguously dominates all others—for example, when a history of high inflation has led the country to invest much of its political and economic capital in the peg, when currency stability is an important part of regional integration, or in small open economies in which there is little value to an independent monetary policy. Otherwise, the authorities should be careful not to deplete most of their reserves in an ill-considered and prolonged defense.
Prudent fiscal policies and measures to promote private saving help to prevent unsustainable current account deficits. Overly expansionary fiscal policy may, for a time, encourage capital inflows and exchange rate appreciation; but growth in foreign indebtedness and upward pressure on the exchange rate cannot be sustained indefinitely. At some point capital flows reverse direction, creating pressures for devaluation. Thus, fiscal control is necessary for a durable peg. In Chile, a sustained period of budget surpluses helped to create room for maneuver for monetary and exchange rate policy and contributed to successful exchange rate management. Poland also benefited from confidence in the sustainability of fiscal policy for much of the period considered. However, the experiences of Mexico and Thailand at the time of their respective 1994–95 and 1997 crises show that the absence of large budget deficits, while necessary, is not sufficient for managing a pegged rate system or a smooth transition to greater flexibility.
Effective supervision and regulation of the banking system decrease the likelihood of future budget deficits and monetization and help keep the country out of the zone where defense of the currency peg becomes too costly. In contrast, a weak financial system may exacerbate exchange market pressures by raising doubts about the willingness of authorities to use interest rates to defend the currency. A depreciation of the currency, as a result of a sudden move to flexible exchange rates, may then undermine bank stability, with the banking sector suffering large losses. In both country cases studied in this paper that involved an abrupt exit from a pegged-exchange-type rate regime (Mexico and Thailand), as well as in several other countries, the associated currency crises had been preceded by significant banking problems (see Tables A4 through A8 in Appendix III) and were in turn followed by severe financial crises.
Speculative attacks are least likely where a country has made a significant political investment in the peg.10 For example, the countries comprising the CFA franc currency zone have, together with France, made a major political commitment to maintain their pegs, which the French Treasury backs with budgetary resources. Central American countries with close economic and trade links to the United States have had particularly long-lasting dollar pegs: in Honduras, the dollar peg lasted from 1918 to 1990; in Guatemala, it lasted from 1926 to 1986.11 The Benelux countries were founding members of the European Union and have made sizable investments in its economic and monetary integration project.12
Small countries that trade extensively with large neighbors and/or have large tourism receipts benefit little from an independent monetary policy. Provided that policy is consistent with this reality, markets are relatively unlikely to challenge relatively fixed exchange rate regimes. Conversely, markets recognize that larger and less open countries may seek to benefit from a degree of monetary autonomy, and may devalue if hit by large negative shocks. For such countries, monetary policy independence can create credibility problems. Containing this difficulty requires enhancing the flexibility of the economy and the financial system by adopting policies that will achieve low inflation, strong external competitiveness, and sustainable growth consistent with the maintenance of a fixed exchange rate.
Policymakers need to be aware of the increasing power of private capital markets. As was made abundantly clear in the EMS crises of 1992–93 and, more recently in several emerging markets, the possibilities for betting against a misaligned exchange rate— or a less-than-credible exchange rate commitment— and the potential gains from winning that bet are enormous. Perceptions of vulnerability are heightened by understandings that the cost of a defense is high when the economy and the financial system are already weak.13 In both Mexico and Thailand, problems affecting banks and finance companies were understood to reduce the likelihood that the authorities would maintain an extended period of high interest rates. Instead of tightening monetary policy substantially in response to the loss of reserves during 1994, the Bank of Mexico kept to its planned path for monetary aggregates, sterilizing reserve outflows through increases in domestic credit, while the government largely replaced its domestic currency debt (Cetes) by short-term debt linked to the value of the dollar (Tesobonos). In Thailand, higher interest rates were supplemented by capital and exchange controls intended to limit the means for speculating against the baht. But while these may have reduced speculation by nonresidents, controls could not contain the hedging of foreign currency exposure belatedly initiated by residents and did not prevent a depreciation.
The timing of speculative attacks is unpredictable and, once under way, their force is hard to resist. Often, exchange rate crises are bunched in time, countries with relatively good fundamentals being attacked along with those whose currencies are more clearly misaligned. This suggests that unequivocal commitments to fixed exchange rate regimes are wise only in cases where the authorities are fully prepared to subordinate all other goals of economic policy to the exchange rate commitment. In other cases, exchange rate commitments, and. more important, the strategy employed in defending a currency under pressure, should embody an appropriate degree of flexibility that takes account of the limits on the ability and willingness of the authorities to adjust economic policies, as well as use intervention, to influence the exchange rate. Moreover, the experience in several countries suggests that even the willingness to raise interest rates to high levels may not ultimately succeed in defending a pegged exchange rate if economic fundamentals (growth, the health of the banking system, and so on) are not satisfactory. The possibility that circumstances for the defense of a pegged rate may not prove to be favorable should be taken into account when choosing the exchange rate regime.