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The Modern History of Exchange Rate Arrangements

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The Modern History of Exchange Rate Arrangements THE QUARTERLY JOURNAL OF ECONOMICS Vol. CXIX February2004 Issue 1 THEMODERN HISTORY OFEXCHANGE RATE ARRANGEMENTS: AREINTERPRETATION* CARMEN M. REINHART AND KENNETH S. ROGOFF Wedevelopa novelsystem of reclassifyinghistorical exchange rate regimes. Onekey differencebetween our study andprevious classi cations is that we employmonthly data on market-determined parallel exchange rates going back to 1946for 153 countries. Our approachdiffers from the IMF of cial classi cation (whichwe show to be only a littlebetter than random); it also differs radically fromall previous attempts at historicalreclassi cation. Our classication points toa rethinkingof economicperformance under alternative exchange rate regimes. Indeed,the breakup of BrettonWoods had less impact on exchangerate regimes thanis popularly believed. I. INTRODUCTION Thispaper rewritesthe history of post-World WarII ex- changerate arrangements, based onan extensivenew monthly data setspanning across153 countriesfor 1946 –2001. Ourap- proachdiffers notonly from countries’ of cially declaredclassi - cations(which weshowto be only a littlebetter than random);it alsodiffers radically fromthe small numberof previous attempts at historicalreclassi cation. 1 *Theauthors wish to thank Alberto Alesina, Arminio Fraga, Amartya Lahiri, VincentReinhart, Andrew Rose,Miguel Savastano, participants at HarvardUni- versity’s Canada-US Economicand Monetary Integration Conference,Interna- tionalMonetary Fund-World Bank JointSeminar, National Bureau of Economic ResearchSummer Institute, New York University,Princeton University, and threeanonymous referees for useful comments and suggestions, and Kenichiro Kashiwase,Daouda Sembene, and Ioannis Tokatlidis for excellent research as- sistance.Data and background material to this paper are available at http://www.puaf.umd.edu.faculty/papers/reinhart/reinhart.htm. 1.The of cial classi cation is givenin theIMF’ s AnnualReport onExchange Rate Arrangements andExchange Restrictions, which,until recently, asked mem- berstates to self-declare their arrangement as belongingto one of four categories. © 2004by thePresident and Fellowsof Harvard Collegeand theMassachusetts Institute of Technology. The Quarterly Journal ofEconomics, February2004 1 2 QUARTERLY JOURNALOF ECONOMICS As a rstinnovation, we incorporate data onparallel and dual exchangerate markets, which have been enormously impor- tant notonly in developingcountries but in virtually all the Europeancountries up until thelate 1950s, and sometimeswell beyond.We argue that any classi cationalgorithm that fails to distinguish betweenuni ed ratesystems (with oneof cial ex- changerate and nosigni cant “black” orparallel market)and all othersis fundamentally awed.Indeed, in thevast majorityof multipleexchange rate or dual systems,the oatingdual or parallel rateis notonly a far betterbarometer of monetarypolicy than istheof cial exchangerate, it is oftenthe most economically meaningfulrate. 2 Veryfrequently —roughlyhalf thetime for ofcial pegs—we ndthat dual/parallel rateshave been used as a form of “back door” oating,albeit oneusually accompaniedby exchangecontrols. The second novelty in ourapproach is that we developextensive chronologies of the history of exchange ar- rangementsand relatedfactors, such as exchangecontrols and currencyreforms. Together with abatteryof descriptive statis- tics,this allows us todraw anuanceddistinction betweenwhat countriesdeclare as theirof cial dejure regime, and theiractual defacto exchange rate practices. To capture the wide rangeof arrangements,our approach allows forfourteen categories of exchangerate regimes, ranging fromno separate legal tender or astrictpeg toa dysfunctional “freelyfalling ” or “hyperoat.” Somehighlights fromour reclassi cationof exchange rate arrangementsare as follows. First, dual, ormultiple rates, and parallel marketshave prevailed far morefrequently than is commonlyacknowledged. In 1950, 45 percentof the countries in oursample had dual or multiplerates; many more had thrivingparallel markets.Among theindustrialized economies,dual ormultiple rates were the Previousstudies have either extended the four-way of cial classicationinto a moreinformative taxonomy (see Ghosh et al.[1997]), or reliedlargely on statis- ticalmethods to regroup country practices(see Levy-Yeyati and Sturzenegger [2002]).The Fund, recognizing the limitations of itsformer strategy, revised and upgradedthe of cialapproach toward classifyingexchange rate arrangements in 1997and again in 1999. Notably, all these prior approaches to exchange rate regimeclassi cation,whether or not they accept thecountry ’sdeclaredregime, havebeen based solely on of cialexchange rates. 2.When we refer to multiple exchange rates in this context, we are focusing onthe cases where one or more of the rates is market-determined. This is very differentfrom the cases where the multiple of cialrates are all xedand simply act asa differentialtax ona varietyof transactions.Dual markets are typically legal,whereas parallel markets may or may not be legal. EXCHANGE RATEARRANGEMENTS 3 normin the1940s and the1950s, and in somecases, these lasted until muchlater. Our data lend strongsupport tothe view stressedby Bordo[1993] that BrettonWoods encompassed two very different kinds ofexchange rate arrangements in thepre- and postconvertibilityperiods and that theperiod of meaningful exchangerate stability was quiteshort-lived. In thedeveloping world,such practices remained commonplace through the 1980s and 1990s and intothe present. Weshow that market-determineddual/ parallel marketsare importantbarometers of underlying monetary policy. This may beobvious in casessuch as modern-dayMyanmar wherethe parallel marketpremium at thebeginning of 2003 exceeded700 percent.As weshow, however, the phenomenon is muchmore general,with theparallel marketpremium often serving as a reliableguide tothe direction of future of cial exchangerate changes.Whereas dual/ parallel marketshave been marginal over someepisodes, they have been economically important in others, and thereare many instances where only a fewtransactions take place at theof cial rate.To assess the importance of secondary (legal orillegal) parallel markets,we collecteddata that allow us toestimate export misinvoicing practices, in manycases going backto 1948. Theseestimates show that leakagesfrom the of cial marketwere signi cant in manyof the episodes when there were dual orparallel markets. Second, whenone uses market-determined rates in place of ofcial rates,the history of exchange rate policy begins to look verydifferent. For example, it becomesobvious that de facto oatingwas commonduring theearly years of theBretton Woods era of “pegged” exchangerates. Conversely, many “oats” of the post-1980s turnout to be (de facto) pegs,crawling pegs,or very narrowbands. Ofcountrieslisted in theof cial IMF classi cation as managed oating,53 percentturned out to have de facto pegs, crawls,or narrow bands tosome anchor currency. Third, nextto pegs (which accountfor 33 percentof the observationsduring 1970 –2001 (according toour new “Natural” classication),the most popular exchangerate regime over mod- ernhistory has beenthe crawling peg,which accounted for over 26 percentof theobservations. During 1990 to2001 this was the mostcommon type ofarrangementin emergingAsia and Western Hemisphere(excluding Canada and theUnited States), making up forabout 36 and 42 percentof the observations, respectively. Fourth, ourtaxonomy introduces a newcategory: freely fall- 4 QUARTERLY JOURNALOF ECONOMICS ing,or thecases where the twelve-month in ationrate is equalto orexceeds 40 percentper annum. 3 It turnsout to be a crowded categoryindeed, with about12 12 percentof the observations in oursample occurring in thefreely falling category.As aresult, “freelyfalling ” is aboutthree times as commonas “freely oat- ing,” whichaccounts for only 4 12 percentof the total observa- tions.(In theof cial classication,freely oatingaccounts for over30 percentof observations over the past decade.)Our new freelyfalling classi cationmakes up 22 and 37 percentof the observations,respectively, in Africa and WesternHemisphere (excluding Canada and theUnited States) during 1970 –2001. In the1990s freelyfalling accountedfor 41 percentof the observa- tionsfor the transition economies. Given the distortions associ- ated with veryhigh in ation, any xed versus exibleexchange rateregime comparisons that do notbreak out the freely falling episodesare meaningless, as weshall con rm. Thereare many important reasons to seeka betterapproach toclassifying exchangerate regimes. Certainly, one is therecog- nitionthat contemporarythinking on the costs and bene ts of alternativeexchange rate arrangements has beenprofoundly in- uencedby thelarge number of studies onthe empirical differ- encesin growth,trade, in ation,business cycles, and commodity pricebehavior. Most have been based ontheof cial classications and all on ofcial exchangerates. In light ofthenew evidence we collect,we conjecture that thein uentialresults in Baxterand Stockman[1989] —that thereare no signi cant differencesin businesscycles across exchange arrangements —may be due to thefact that theof cial historicalgroupings of exchange rate arrangementsare misleading. Thepaper proceedsas follows.In thenext section we present evidenceto establish theincidence and importanceof dual or multipleexchange rate practices. In SectionIII wesketch our methodologyfor reclassifying exchange rate arrangements. Sec- tionIV addresses someof the possible critiques to our approach,
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