Floating Exchange Rates at Fifty by Douglas A. Irwin

Author:Douglas A. Irwin
Language: eng
Format: epub
ISBN: 9780881327502
Publisher: Peterson Institute for International Economics

18

Emerging Markets and the

Transition to Stability: Role of

Flexibility of Exchange Rates

JOSÉ DE GREGORIO

José De Gregorio, nonresident senior fellow at the Peterson Institute for International Economics, is dean of the School of Economics and Business at the University of Chile. He was governor of the Central Bank of Chile from 2007 until 2011.

Implementation of flexible exchange rate regimes in emerging-market economies (EMEs) occurred long after the dissolution of the Bretton Woods system, following numerous unsuccessful attempts to combat inflation through fixed exchange rates and severe fear of floating. Until the late 1990s, most crises in EMEs were linked to inflexible exchange rate regimes, as evident in the Latin America debt crisis in the 1980s, the Mexican crisis in 1994, the Asian financial crisis in 1997–98, and the Russian default with contagion to Brazil in 1998. These episodes were characterized by a combination of fragile financial systems and rigid exchange rate frameworks.

EMEs gradually transitioned toward greater exchange rate flexibility, leading to the emergence of new questions. In an environment where a significant portion of international trade is conducted and priced in US dollars (Gopinath et al. 2020), are exchange rates still effective in facilitating external adjustment? Do EMEs experience wealth losses when their currencies depreciate? How much does depreciation affect local borrowers, including the government?

This chapter examines the transition toward more flexible exchange rate regimes in EMEs, a phenomenon that coincided with a decline in global inflation and the adoption of inflation targeting frameworks. It analyzes the capacity of exchange rates to foster external adjustment, taking into account recent research in international pricing that casts doubt on their effectiveness. It also looks at currency mismatches and the implications for the net international investment position of EMEs and the effects of exchange rate fluctuations.

Inflation, Monetary Policy, and the Exchange Rate Regime

EMEs have been the prime example of fear of floating (Calvo and Reinhart 2002). Fear of floating arises for two reasons. The first is concerns about the inflationary effects of currency depreciation associated with the lack of credibility that leads to high exchange rate pass-through (ERPT). The second is the fear that currency depreciations may lead to financial disruptions, even to self-fulfilling equilibria. In this section I focus on inflation in EMEs and the monetary policy regime.

In the late 1990s, three main developments took place:

•Inflation declined. Even in Latin American economies characterized by high inflation, rates fell to single digits for the first time in decades (figure 18.1).

•Many countries adopted flexible inflation targeting regimes, characterized mainly by commitment to a specific value or range for the inflation rate, to be achieved in the medium term, with or without specifying a policy horizon (figure 18.2). Several countries announced that the target would be achieved within two years; others just mentioned the medium term.1

•Most EMEs abandoned pegged exchange rate regimes, moving to some type of intermediate regime, ranging from narrow bands to managed floating (figure 18.3).2 It is difficult to find fully floating regimes, as most countries that adopt flexibility retain the possibility of intervention in some special circumstances; others follow some rules to provide some stability in the short run.

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