Exchange rate regime choice and currency crises
Highlights
► Pursuing a regime that is inconsistent with a country's features increases the odds of currency crises. ► In crisis-hit peggers and floaters especially, regime determinants actually imposed different regimes than those at work. ► Overvaluation of RER and output gap, as expected, posed problems for more rigid exchange rate regimes. ► Contagion effects are observed in the making of crises across all regimes, but for floaters they are more pronounced. ► Capital account openness decreases the odds of crisis, an indication of the discipline imposed by liberalized financial markets.
Introduction
This paper aims to fill the gap between the exchange rate regime choice (ERRC) and currency crisis (CC) literatures by bringing the question of appropriateness of the regime to the forefront in analyzing the currency crisis. The exchange rate regime can be viewed as a stage on which real and nominal shocks interact with macroeconomic policies conducted by the authorities. As indicated by the ERRC literature, exchange rate regime choice is not exogenous, but depends on the structural, political and financial features of countries. However, it is often the case that the regime actually pursued and the one that is imposed by country features may not match one to one. There are obvious reasons; using pegged regimes to tame inflationary expectations has been a widely adopted policy in high inflation countries.1 This is not costless, however. The trade-off between the sustainability of the regime and the desire for macroeconomic stability often resulted in missing both targets as currency crises episodes in the last couple of decades clearly indicate. Yet, the existing empirical literature on currency crisis, by and large, does not take into account this point, namely the question of appropriateness of the ongoing regime within which the crisis is unfolded. The implicit assumption that the occurrence of a currency crisis is independent of the regime choice is a very strong one, and one which carries the potential to bias estimation results.
As Frankel (1999) puts it, “the choice of exchange rate arrangement should depend on the particular circumstances facing the country in question”. From the sustainability point of view, the immediate question that may follow this statement is what happens if the regime that has been chosen does not match those “particular circumstances”. Does this discrepancy provide a fertile ground for vulnerabilities to grow, or not? Or, put differently, do real, nominal or policy shocks affect countries in the same direction regardless of the regimes at work?
The most common reason behind choosing a regime other than what is optimal is the desire for macroeconomic stability. Especially following the collapse of Bretton Woods in the mid-1970s, countries started to use exchange rate regimes as a tool to stabilize their economies. In the so-called exchange-rate-based stabilization (ERBS) programs, exchange rates represent the nominal anchor for stabilizing chronic high inflation. However, these programs are heavily criticized on the grounds that they led to excess volatility in the domestic economy, see Calvo and Vegh (1999), Tornell and Westermann (2002), Hamann et al. (2005) and Ranciere et al. (2005). For example, less-than-perfectly credible exchange rate stabilization programs may trigger a consumption boom as agents increase their demand for consumption or investment goods when these are “cheap”, in other words, before the eventual collapse of the currency. The studies mentioned above clearly show that an “inappropriate” choice of regime (a choice that is inconsistent with the structural, political and financial features of the country) is not costless. And this is exactly the juncture where this study kicks in.
To our knowledge, this paper is the first study investigating the question of regime appropriateness in the context of currency crises. The line of reasoning is that different country characteristics require different regimes and unless the regimes are consistent with those characteristics, countries gradually become more vulnerable to adverse shocks which may lead them to crisis.
In the paper we will use the IMF's de facto regime classification.2 The sample consists of 163 developed and developing countries and covers the period between 1990 and 2007.
The outline of the paper is as follows: in the coming section we will review the relevant studies in ERRC and CC literatures and discuss the link between regime choice and currency crises. In the methodology part, we will describe the important steps of our analysis. After discussing the regression results, in Section 4 we will conduct a battery of robustness checks to test the validity of our results. In the final part we will conclude.
Section snippets
Literature review
This study aims to fill the gap between the CC and ERRC literatures by incorporating the question of appropriateness of the regime choice into the standard early-warning crisis models.
The interest in currency crisis took a fresh start following the collapse of the Bretton Woods system in the mid-1970s. In the absence of a properly functioning and universally accepted international monetary system, many countries/regions are faced with a dilemma between macroeconomic and exchange rate stability.
Methodology
The main steps of the analysis of this paper are as follows: we first start by grouping countries under three regimes, then for each regime group we identify the crisis and tranquil cases using 18 months windows.13
Robustness checks
In this section we will test the validity of our baseline regression results by employing a battery of robustness checks. In this vein, we will first test our model using a different classification scheme offered by Reinhart and Rogoff (2004).
Once we check to what extent the regime classification of two schemes match one to another, we see that two schemes yielded the same broad group (pegged, intermediate or float) only 44% of the time on average.
Table 7 presents the multinomial crisis model
Concluding remarks
Exchange rate regime choice is endogenous; it has many determinants as indicated by the ERRC literature. Although one can put forward many valid arguments to use exchange rate regimes as a credibility-enhancing tool, countries should keep in mind the negative consequences of inconsistently chosen regimes. Our study revealed that pursuing a regime that is inconsistent with a country's features increases the odds of currency crises. That is, the choice is not neutral, but it has costs. Pegged
Acknowledgements
I would like to thank the participants of the 15th ERF Conference held in Cairo in December, 2008, and the three anonymous referees for their useful comments.
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