The Cost of Tying One’s Hands

• Author: Atish R. Ghosh, Mahvash S. Qureshi, and Charalambos G. Tsangarides
• Position: an Assistant Director, is an Economist, and is a Senior Economist, all in the IMF’s Research Department.

Meeting in Mexico City in November 2012, the Group of Twenty finance ministers and central bank governors declared that “the weak pace of global growth also reflects limited progress towards sustaining and rebalancing global demand. . . . In this regard, we reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals. . . .”

The importance of exchange rate flexibility in facilitating the adjustment of current account imbalances has long dominated international policy debates. Before the global financial crisis, the debate focused on global imbalances and how exchange rate policies of several large Asian and oil-exporting countries with external surpluses perpetuated those imbalances. Since the crisis, the challenges confronting many emerging market and advanced economies in Europe have rekindled interest in the relationship between exchange rate flexibility and external adjustment—on both the deficit and surplus sides.

Is there a connection between exchange rate flexibility and external adjustment? Writing in the heyday of the Bretton Woods system of monetary management, the influential economist Milton Friedman (1953) argued that under flexible exchange rates “changes in [the exchange rate] occur rapidly, automatically, and continuously and so tend to produce corrective movements before tensions can accumulate and a crisis develop.”

Thus, in deficit countries, the currency would depreciate, restoring competitiveness and narrowing the deficit; in surplus countries, the currency would appreciate, shrinking the surplus. Under fixed exchange rates, by contrast, the burden of adjustment in deficit countries would fall entirely on downwardly rigid goods and factor prices, while surplus countries would face no compelling adjustment mechanism. A direct corollary of this argument is that external imbalances (current account surpluses or deficits) are less persistent under floating than under fixed exchange rates, reducing the likelihood that dangerous imbalances will build up and eventually precipitate a crisis.

The emerging market financial crises of the 1990s (which all occurred under some form of pegged regime), the large current account deficits in eastern European countries in the run-up to the global financial crisis, and the ongoing efforts of some euro area countries, such as Greece, Portugal, and Spain, all bespeak delayed and more difficult external adjustment under pegged exchange rates. In fact, it is striking that the majority of recent IMF arrangements are with countries that had some form of managed exchange rate regime on the eve of the crisis in 2007 (see Chart 1).

This pattern is consistent with the findings in several empirical studies of a strong association between pegged exchange rates and vulnerability to crises, abrupt reversals of the current account, and growth collapses (for example, Milesi-Ferretti and Razin, 1996; Ghosh, Ostry, and Qureshi, 2014). A natural inference is that the inflexibility of the nominal exchange rate prevents timely external adjustment until large imbalances build up, precipitating a crisis.

While this argument seems compelling, formal evidence that pegged exchange rates impedeâand floating exchange rates facilitateâexternal adjustment is surprisingly scant and contradictory. For example, in a large cross-country study, Chinn and Wei (2013) find no empirically strong or robust relationship between the exchange rate regime and the rate at which current account...