The Continuing Bipolar Conundrum

• Author: Andrea Bubula/Inci Otker-Robe
• Position: Lecturer in Economics and International Affairs at Columbia University/Deputy Division Chief in the IMF's Monetary and Financial Systems Department
• Pages: 32-35

Some countries are abandoning intermediate exchange rate regimes although the trend is not as strong as might be expected

Page 32

The major currency crises of the past decade have led many observers to associate pegged exchange rates, particularly soft pegs, with proneness to crises. From the European exchange rate mechanism turmoil of 1992-93 to the crises in Mexico (1994), Asia (1997), Russia (1998), Brazil (1998), Ecuador (1999), and Turkey (2001), some kind of pegged or tightly managed exchange rate regime was in place prior to the crisis. The intensity and scope of the crises, which were accompanied in many cases by a collapse of the banking system and economic activity, were overwhelming. As a result, there has been growing support for the view that intermediate regimes between hard pegs and floats- that is, soft peg regimes and tightly managed floats (see Chart 1)-cannot be viable for long periods, particularly in economies that are very open to international capital flows.

Those who espouse this "bipolar" view of exchange rate regimes-pioneered by, among others, Stanley Fischer, former IMF First Deputy Managing Director-argue that pegs cannot be sustained with the current degree of financial market integration unless countries make an irrevocable commitment to the peg and are prepared to support it with necessary policies and institutions (as in hard pegs). A country's only feasible alternative to such a commitment is to float, thereby acquiring greater monetary autonomy and limiting speculative capital flows that often follow highly predictable exchange rates. The proponents of the bipolar view also maintain that countries are moving away from crisis-prone intermediate regimes.

Chart 1

The current spectrum of exchange rate regime categories

[ SEE THE GRAPHIC AT THE ATTACHED PDF ]

The bipolar view, however, has been challenged on several grounds. For one, a country's actual (de facto) exchange rate regime often differs from its de jure, or officially announced, policy, raising questions about whether the observed trend away from intermediate regimes is a fallacy (Calvo and Reinhart, 2000). Moreover, the regimes at the extremes (as opposed to the middle) of the spectrum could also be subject to market pressures, as demonstrated by the collapse of Argentina's currency board at the end of 2001 or Brazil's currency market worries in 2001 under a free float, among others. Further, there has been no solid empirical evidence to support the view that intermediate regimes would eventuallyPage 33 vanish (Masson, 2001). Noting that no single regime would be right for all countries at all times, some observers have therefore argued for a continued role for intermediate regimes (for example, Frankel, 1999).

But if countries' exchange regimes were characterized on the basis of actual, as opposed to official, policies, would the bipolar view still hold? Our study explores the incidence of currency crises under alternative exchange rate regimes during 1990-2001 and analyzes whether countries have indeed been moving toward less crisis-prone regimes. The analysis is based on a data set of de facto regimes of a large number of IMF members (see box, page 35), on the premise that an appropriate characterization of actual regimes is essential for an accurate assessment of their evolution and susceptibility to crises. A failure to recognize, for example, that a country may be informally pegging under an officially declared float may lead to misleading conclusions that exchange rate regimes have been evolving toward greater flexibility or that floating regimes are as susceptible to crises as pegged regimes when the currency comes under speculative pressure.

Crisis proneness

Which regimes are more crisis prone? In our study, we looked at de facto exchange rate regimes in more than 150 countries. We found that pegged...