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Eduardo Levy Yeyati The World Bank & Universidad Torcuato Di Tella December, 2006

Fear of Floating or Fear of Flying: Exchange Rate Policy in the New Millenium. Eduardo Levy Yeyati The World Bank & Universidad Torcuato Di Tella December, 2006. Storyboard. The basics: T he debate post-Bretton Woods The tradeoff: Exchange rate regimes and the real economy

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Eduardo Levy Yeyati The World Bank & Universidad Torcuato Di Tella December, 2006

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  1. Fear of Floating or Fear of Flying: Exchange Rate Policy in the New Millenium Eduardo Levy Yeyati The World Bank & Universidad Torcuato Di Tella December, 2006

  2. Storyboard • The basics: The debate post-Bretton Woods • The tradeoff: Exchange rate regimes and the real economy • The evidence: Regimes in the 2000s • The FIT (float + inflation targeting) paradigm: natural evolution or fad? • Fear of flying: building a case for a proactive exchange rate policy

  3. The basics • The real view (‘70s) • Trade (and welfare) gains vis à vis users of the peg currency vs. loss of the exchange rate as a shock absorber in the presence of nominal rigidities. • Pro peg  Openness, propensity to trade, trade concentration • Pro float  Incidence of real shocks

  4. The basics • The political view (‘80s) • Bands, “tablitas” & other soft species: Exchange rate anchors as a “policy crutch” to compensate for the lack of monetary credibility or political power • Pro peg  high inflation, weak governments

  5. The basics • The financial view (‘90s) • The trilemma: as the world integrates, countries have to choose between monetary autonomy & a stable ER • The bipolar view: Exchange rate policy in emerging economies become more vulnerable to the limits imposed by the trilemma: hard peg or float • The unipolar view: Balance sheet effects due to currency mismatches limit the scope for expansionary devaluations  Hard pegs

  6. The tradeoff • Oversimplifying: • Fix vs. flex  Enhanced monetary & fiscal discipline (lower inflation) at the cost of greater sensitivity to real shocks & output volatility… • …except under FD (contractionary devaluations) • Is this theoretical tradeoff validated by the evidence? • Yes

  7. The tradeoff • Preliminary evaluation: • Pegs contribute to lower inflation expectations… • …at the cost of greater output volatility…

  8. Regimes & output volatility Source: Edwards - LY (2005)

  9. The tradeoff • Preliminary evaluation: • Pegs contribute to lower inflation expectations… • …at the cost of greater output volatility… • …and slower growth

  10. Regimes & growth Source: LYS (2003)

  11. The tradeoff • Preliminary evaluation: • Pegs contribute to lower inflation expectations… • …at the cost of greater output volatility… • …and lower growth • Balance sheet effects • Subdued inflation fears  Volatility concerns dominate  Float • Under FD  Threshold floats • The bipolar view after Argentina

  12. Argentina: Fiscal (in)discipline Source: De la Torre-Schmukler-LY (2002)

  13. Argentina: Monetary (in)discipline Source: De la Torre-Schmukler-LY (2002)

  14. The bipolar view after Argentina • Lack of external discipline by private markets Hard pegs do not lead to fiscal discipline • Fiscal dominance  Hard pegs do not lead to monetary discipline • Is de jure dollarization hard enough?

  15. Where do we stand? • Pegs are passé In most cases, inefficient short-term substitute for credibility • Hard pegs failed the test in Argentina • Learning to live with BS effects  The (dynamic) scope for countercyclical exchange rate policy • The double D: Domestication and de-dollarization of sovereign debt • A unipolar view in reverse?

  16. Exchange rate regimes in the 2000s: Classification • Key criterion: ER variability relative to forex intervention • The intervention dimension is key to characterized exchange rate policy (as opposed to the evolution of exchange rates) and its consequences

  17. De facto regimes over the years: Distribution Source: LYS (2006)

  18. Emerging LATAM: A FIT paradigm? Source: LYS (2006)

  19. The FIT paradigm • Natural evolution or this year’s model? • Less than a paradigm, more than a fad • Negative experience with alternative options • Inflation awareness  CB autonomy, fiscal restraint • Decline in inflation –and dollar indexation– tilts the balance towards more flexibility • Inflation targets substitute for ER anchors • Still far from the benign neglect

  20. The comeback of exchange rate policy? • Mercantilist interventions as a substitute for protection • Less specific than subsidies • Less prone to mismanagement & corruption • Fear of floating or fear of flying? • Invertion of the ER anchor problem: sustaining an undervalued currency • Instead of amplified recessions due to price rigidities… • …inflationary expansions fueled by positive real shocks. • Does it work? How?

  21. Fear of flying: A characterization • Fear of floating’s underlying fears: • Contractionary devaluations (due to BS effects) and currency and debt crisis propensity • Dollar pricing, pass-through and inflation • Fear of flying: Leaning against the appreciation wind • Intervention to strenthen the demand for the foreign currency, to avoid/mitigate appreciation pressures

  22. Fear of flying over time (intermediates) Source: LYS (2006)

  23. Fear of flying over time (non-floats) Source: LYS (2006)

  24. …to avoid/mitigate appreciation pressures Additional controls: country and time FE, terms of trade, GDP of trade partners, net inflows. Source: LYS (2006)

  25. Real Exchange Rate Plot Source: LYS (2006)

  26. Does it work? ∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2 Additional controls: country and time FE, terms of trade shocks, growth of pop., growth of trade partners, net inflows. Source: LYS (2006)

  27. Does it work? Growth Trend Cycle Source: LYS (2006)

  28. How? ∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2. Additional controls: country and time FE, ToT shocks, pop. growth., growth of trade partners, net inflows. Source: LYS (2006)

  29. How? ∆(foreign_assets/M2): Change in the ratio of foreign assents by the Central Bank and M2. ∆Log(ToT): Change of logarithm of terms of trade. Source: LYS (2006)

  30. Savings & investment Source: LYS (2006)

  31. Taking stock • Dedollarization and debt reduction reduce the incidence of capital reversals • Soft FIT paradigm replaces the ER as nominal anchor • Fear of flying is an increasingly popular contender to drive domestic saving & investment (but not so much exports) • The exchange rate debate appears to have gone full circle to the issues of the 1970s

  32. Thank you

  33. Fear of Floating or Fear of Flying: Exchange Rate Policy in the New Millenium Eduardo Levy Yeyati The World Bank & Universidad Di Tella December, 2006

  34. Balance sheet effects & crisis propensity Logit model - Dependent variable: Crisis dummy Source: LY (2006)

  35. Balance sheet effects & crisis propensity Controlling for deposit dollarization ratios

  36. De facto regimes over the years: Classification • Exchange rate volatility (e): average of the absolute value of monthly changes in the exchange rate • Volatility of exchange rate changes (e ): standard deviation of monthly changes in the exchange rate • Volatility of reserves (R): average of the absolute value of monthly changes in international reserves relative to the monetary base of the previous month (both denominated in US dollars)

  37. De facto regimes over the years: Classification

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