Is a G-3 Target Zone on Target for Emerging Markets?

• Author: Carmen M. Reinhart and Vincent Raymond Reinhart
• Position: Professor of Economics at the University of Maryland when the paper on which this article is based was prepared, is Assistant Director in the IMF's Research Department/Director of Monetary Affairs at the Board of Governors of the U.S. Federal Reserve System

Would the exchange rate stability created by a target zone for the world's three most important currencies be in the best interests of emerging market countries? A recent study suggests such stability might come at the price of more volatile interest rates, making this a difficult question to answer.

As fashions in exchange rate arrangements have changed over the years, proposals to establish a target zone for exchange rate fluctuations among the world's three major currencies-the dollar, the deutsche mark (now replaced by the euro), and the yen-have remained hardy perennials. The thinking has been that target zones-permissible ranges of fluctuations in exchange rates, measured in percent, to which the countries issuing those currencies agree-would offer industrial countries greater exchange rate stability since the collapse of fixed exchange rates.

The pioneering work on target zones done by Ronald McKinnon and John Williamson focused mostly on the potential benefits for the industrial world. In recent years, however, analysts have begun to wonder if emerging market countries might benefit, too, because many of their currencies are tied to the dollar, either implicitly or explicitly. After all, the volatility of industrial country exchange rates was considered a factor in the financial crises that plagued emerging markets in the late 1990s. In particular, the prolonged appreciation of the dollar vis-à-vis the yen and the deutsche mark before the Asian crisis was viewed as having worsened the competitive positions of many emerging market economies.

One way to reduce destabilizing shocks emanating from abroad, the argument runs, would be to reduce the variability of the exchange rates between the Group of Three (G-3) currencies-which are those of the United States, Japan, and the 12 members of the euro area (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain) by establishing target zones. Would this be a good deal for emerging market countries? To answer this question, we examined the impact over the past thirty years of fluctuations in G-3 exchange rates and interest rates on 128 developing countries. Our findings should give advocates of such a target zone pause.

The interest rate trade-off

Essential to understanding the costs and benefits of a target zone is answering the question: how would the G-3 central banks (the U.S. Federal Reserve System, the...