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Multi0page.Pdf Africa Region Working Paper Series ( Number16 16 2 7 (f 0 Public Disclosure Authorized Choice of ExchangeRate, Regimes for DevelopingCountries Fahrettin Yagci Public Disclosure Authorized April2001 Public Disclosure Authorized 0 0>.L 0C Public Disclosure Authorized Choice Of Exchange Rate Regimes For Developing Countries April 2001 Africa Region Working Paper Series No. 16 Abstract The choice of an appropriate exchange rate regime for developing countries has been at the center of the debate in international finance for a long time. What are the costs and benefits of various exchange rate regimes? What are the determinants of the choice of an exchange rate regime and how would country circumstances affect the choice? Does macroeconomic performance differ under alternative regimes? How would an exchange rate adjustment affect trade flows? The steady increase in magnitude and variability of international capital flows has intensified the debate in the past few years as each of the major currency crises in the 1990s has in some way involved a fixed exchange rate and sudden reversal of capital inflows. New questions include: Are pegged regimes inherently crisis-prone? Which regimes would be better suited to deal with increasingly global and unstable capital markets? While the debate continues, there are areas where some consensus is emerging, and there are valuable lessons from earlier experience for developing countries. This note provides a review of the main issues in selecting an appropriate regime, examines where the debate now stands, and summarizes the consensus reached and lessons learned from recent experience. Authors' Affiliation and Sponsorship Fahrettin Yagci Lead Economist, AFTM1, The World Bank E-mail: [email protected] THE WORKINGPAPER SERIES The Africa Region WorkingPaper Seriesexpedites dissemination of appliedresearch and policy studies with potential for improvingeconomic performance and social conditions in Sub-SaharanAfrica. The Series publishespapers at preliminarystages to stimulatetimely discussionwithin the Region and among client countries,donors, and the policy research community. The editorial board for the Series consists of representativesfrom professionalFamilies appointed by the Region's Sector Directors. Editor in charge of the series: Antoine Waldburger,AFTM3, Email: [email protected],who may be contactedfor hard copies. Foradditional information visit the Website http://wwwdworldbank.org/afr/wps/index.htm, wherecopies are availablein pdf format. Thefindings, interpretations, and conclusions expressed in thispaper are entirelythose of the author(s). Theydo not necessarilyrepresent the views of theWorld Bank Group, its ExecutiveDirectors, or the countriesthat they represent and should not be attributedto them. CHOICE OF EXCHANGE RATE REGIMES FOR DEVELOPING COUNTRIES Fahrettin Yagci Lead Economist, AFTM1, The World Bank E-mail: fyagci~worldbank.org April 2001 Acknowledgement This paper was prepared for a workshop sponsored by the National Economic Consultative Forum to discuss the exchange rate issues in Zimbabwe to be held in April 2001 in Harare. Valuable comments were received from Philippe Le Houerou, Larry Hinkle, Hinh Dinh, Jose Leandro, Jeffrey Lewis, James Sackey, David Bruns, Sudhir Chitalle, Peter Moll and from participants in the AFTM I review meeting. The views expressed do not necessarily reflect those of the World Bank or its members. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s). They do not necessarilyrepresent the views of the WorldBank Group, its ExecutiveDirectors, or the countriesthat theyrepresent and shouldnot be attributedto them. TABLE OF CONTENTS Page A. Introduction ............................................... 1 B. Classification of Exchange Rate Regimes ........................................... 3 C. Main Determinants of the Choice of Exchange Rate Regimes ......... ........... 7 D. Issues in Selection of Exchange Rate Regimes ........................ ............. 9 Policy Activism .............................................. 9 Discipline and Credibility ...................... ........................ 9 Volatility and Misalignment ........................... ................... 10 Vulnerability to Currency Crisis .............................................. 11 Independence of Monetary Policy and Nominal Anchor .......... .............. 13 Vulnerability to Shocks ................. ............................. 14 Regional Exchange Rate Arrangements .......................................... 15 Time Horizon and Exit ................ .............................. 16 The Impossible Trinity .............................................. 17 E. Complementary Macroeconomic Policies ............................................ 17 F. Changing Pattern of Exchange Rate Regimes .............................. ......... 19 G. Exchange Rate Regimes for the Three Major Currencies ....... .................. 22 H. Macroeconomic Performance Under Alternative Regimes ........... ............. 23 I. Impact of an Exchange Rate Adjustment on Inflation, Growth and Trade Flows 24 References .............................................. 26 A. Introduction 1. An exchange rate, as a price of one country's money in terms of another's, is among the most important prices in an open economy. It influences the flow of goods, services, and capital in a country, and exerts strong pressure on the balance of payments, inflation and other macroeconomic variables. Therefore, the choice and management of an exchange rate regime is a critical aspect of economic management to safeguard competitiveness, macroeconomic stability, and growth'. 2. The choice of an appropriate exchange rate regime for developing countries has been at the center of the debate in international finance for a long time. What are the costs and benefits of various exchange rate regimes? What are the determinants of the choice of an exchange rate regime and how would country circumstances affect the choice? Does macroeconomic performance differ under alternative regimes? How would an exchange rate adjustment affect trade flows? The steady increase in magnitude and variability of international capital flows has intensified the debate in the past few years as each of the major currency crises in the 1990s has in some way involved a fixed exchange rate and sudden reversal of capital inflows. New questions include: Are pegged regimes inherently crisis-prone? Which regimes would be better suited to deal with increasingly global and unstable capital markets? While the debate continues, there are areas where some consensus is emerging, and there are valuable lessons from earlier experience for developing countries. This note provides a review of the main issues in selecting an appropriate regime, examines where the debate now stands, and summarizes the consensus reached and lessons learned from recent experience 2. 3. A growing consensus seems to be emerging on the following: (a) Selection of an exchange rate regime that is most likely to suit a country's economic interest would depend on a variety of factors including: specific country circumstances (the size and openness of the country to trade and financial flows, structure of its production and exports, stage of its financial development, its inflationary history, and the nature and source of shocks it faces); policymakers' preferences for the trade offs among the main policy objectives; political conditions in the country; and the credibility of its policy makers and institutions. Therefore, there is no single ideal exchange rate regime that is appropriatefor all countries. The actual choice from an array of regimes depends on the relative weight given to each of these factors. In addition, an exchange rate regime appropriate for a country would change over time with changing country circumstances. "For most countries... the choiceof exchangerate policyis probablytheir singlemost importantmacroeconomic policy decision,strongly influencing their freedomof actionand effectivenessof other macroeconomicpolicies, the evolutionof their financialsystem, and even the evolutionof their economies"Cooper (1999). 2 This paper complementsthree studiessponsored by the NationalEconomic Consultative Forum (NCEF) - a think- tank comprisingbusiness, government, and other stakeholdersin Zimbabwe- to reviewthe exchangerate managementin the 1990sin Zimbabweand assessthe impact of an exchangerate adjustmenton exportsand inflation. The studieswere recentlycompleted by a group of localresearchers and presentedto the government (Ndlela2000, Ndlelaand others2000, Sikwila2000). They will be discussedin a workshopin Harare in April 2001. l (b) The steady increase in magnitude and variability of international capital flows in the past two decades has undermined the viability of soft peg arrangements (fixed, adjustable peg, and narrow band exchange rate regimes). A number of emerging market economies integrated or integrating into international capital markets with soft peg regimes have experienced severe currency crisis and economic disruption in the 1990s. As a result, an increasing number of countries are moving toward the ends of the spectrum - that is, independent floating exchange rates on the one end to dollarization on the other. This "disappearing middle" does not mean that all countries should move to the very ends of the spectrum. Intermediate regimes such as crawling bands could be viable alternatives if they are supported
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