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«Exchange-Rate Pegging in Emerging-Market Countries? by Frederic S. Mishkin Graduate School of Business, Columbia University, and National Bureau of ...»

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Exchange-Rate Pegging in Emerging-Market Countries?

by

Frederic S. Mishkin

Graduate School of Business, Columbia University,

and

National Bureau of Economic Research

Phone: 212-854-3488, Fax: 212-316-9219

E-mail: fsm3@columbia.edu

June 1998

I thank Adam Posen, Robert Hodrick, an anonymous referee and participants in the macro lunch at

Columbia University for their helpful comments. Any views expressed in this paper are those of

the author only and not those of Columbia University or the National Bureau of Economic Research.

ABSTRACT This paper examines the question of whether pegging exchange rates is a good strategy for emergingmarket countries. Although pegging the exchange rate provides a nominal anchor for emerging market countries that can help them to control inflation, the analysis in this paper does not provide support for this strategy for the conduct of monetary policy. First there are the usual criticisms of exchange-rate pegging, that it entails the loss of an independent monetary policy, exposes the country to the transmission of shocks from the anchor country, increases the likelihood of speculative attacks and potentially weakens the accountability of policymakers to pursue antiinflationary policies. However, most damaging to the case for exchange-rate pegging in emerging market countries is that it can increase financial fragility and make the potential for financial crises more likely. Because of the devastating effects on the economy that financial crises can bring, an exchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries.

Instead, this paper suggests that a strategy with a greater likelihood of success involves the granting of independence to the central bank and inflation targeting.

Frederic S. Mishkin Graduate School of Business Uris Hall 619 Columbia University New York, New York 10027 and NBER fsm3@columbia.edu I. Introduction In recent years, there has been a growing consensus, even in emerging-market countries, that controlling inflation should be the primary or overriding long-term goal of monetary policy. Past experience with high inflation in emerging-market countries has not been a happy one, and there is a growing literature that suggests that high inflation can be an important factor that retards economic growth.1 Although central bankers, as well as the public, in emerging-market countries now put more emphasis on controlling inflation, there is still the crucial question of how best to do this. To achieve low inflation, one choice thatemerging-market countries have often made is to peg their currency to that of a large, low-inflation country, typically the United States.2 Is this choice a good one?

This paper examines the question of whether pegging its exchange rate is a good strategy for emerging-market countries. The analysis here suggests that the answer is usually no, except in extreme circumstances where a particularly strong form of exchange-rate pegging might be worth pursuing. Indeed, an important point in the analysis of this paper is that pegging the exchange rate is a less viable strategy for emerging-market countries than it is for industrialized countries.

After examining rationales for exchange-rate pegging, the paper discusses criticisms of exchange rate pegging and why it is so dangerous for emerging-market countries. Because the paper argues that exchange-rate pegging is highly problematic for emerging-market countries, it then goes on to explore what other strategies for inflation control might be reasonable alternatives in these countries. The paper ends with some concluding remarks.

II.

See, for example, Anderson and Gruen (1995), Briault(1995), Bruno (1991), Feldstein (1997), Fischer (1993, 1994) and Sarel (1996).

In some cases, this strategy involves pegging the exchange rate at a fixed value to that of the other country so that its inflation rate will eventually gravitate to that of the other country, while in other cases it involves a crawling peg or target in which its currency is allowed to depreciate at a steady rate so that its inflation rate can be slightly higher than that of the other country.

Rationales for Exchange-Rate Pegging Fixing the value of an emerging-market's currency to that of a sounder currency, which is exactly what an exchange-rate peg involves, provides a nominal anchor for the economy that has several important benefits. First, the nominal anchor of an exchange-rate peg fixes the inflation rate for internationally traded goods, and thus directly contributes to keeping inflation under control.

Second, if the exchange-rate peg is credible, it anchors inflation expectations in the emerging-market country to the inflation rate in the anchor country to whose currency it is pegged. The lower inflation expectations that then result bring the emerging-market country's inflation rate in line with that of the low-inflation, anchor country relatively quickly.

Another way to think of how the nominal anchor of an exchange- rate peg works to lower inflation expectations and actual inflation is to recognize that if there are no restrictions on capital movements, then a serious commitment to an exchange-rate peg means that the emerging-market country has in effect adopted the monetary policy of the anchor country. As long as the commitment to the peg is credible, the interest rate in the emerging-market country will be equal to that in the anchor country. Expansion of the money supply to obtain lower interest rates in the emerging-market country relative to that of the low-inflation country will only result in a capital outflow and loss of international reserves that will cause a subsequent contraction in the money supply, leaving both the money supply and interest rates at their original levels. Thus, another way of seeing why the nominal anchor of an exchange-rate peg lowers inflation expectations and thus keeps inflation under control in an emerging-market country is that the exchange-rate peg helps the emerging-market country inherit the credibility of the low-inflation, anchor country's monetary policy.





A further benefit of having an exchange-rate peg as a nominal anchor in an emerging market country is that it helps provide a discipline on policymaking that avoids the so-called timeinconsistency problem described by Kydland and Prescott (1977), Calvo (1978) and Barro and Gordon (1983). The time-inconsistency problem arises because there are incentives for a policymaker to pursue discretionary policy to achieve short-run objectives, such as higher growth and employment, even though the result is poor long-run outcomes -- high inflation. The timeinconsistency problem can be avoided if policy is bound by a rule that prevents policymakers from pursuing discretionary policy to achieve short-run objectives. Indeed, this is what an exchange rate peg can do if the commitment to it is strong enough. With a strong commitment to it, the exchange rate peg eliminates discretionary monetary policy and implies an automatic policy rule that forces a tightening of monetary policy when there is a tendency for the domestic currency to depreciate or a loosening of policy when there is a tendency for the domestic currency to appreciate.

As McCallum (1995) has pointed out, simply by recognizing the problem that forwardlooking expectations in the wage- and price-setting process creates for a strategy of pursuing expansionary monetary policy, central banks can decide not to pursue expansionary policy which leads to inflation. However, even if the central bank recognizes the problem, there still will be pressures on the central bank to pursue overly expansionary monetary policy by the politicians that can lead to this outcome, so that the time-inconsistency problem remains: the time-inconsistency problem is just shifted back one step. The simplicity and clarity of an exchange rate peg can help reduce pressures on the central bank from the political process because the exchange-rate peg is easily understood by the public, providing a "maintenance of a sound currency" as an easy-tounderstand rallying cry for the central bank. Thus, an exchange-rate peg can help the monetary authorities to resist any political pressures to engage in time-inconsistent policies.

With all of these advantages of an exchange-rate peg as a strategy for controlling inflation in emerging market countries, it is not surprising that many of these countries have adopted this strategy.3 However, as we will see in the next two sections, there are sufficient dangers in pursuing an exchange-rate peg, that it may produce poor economic outcomes in most emerging market countries.

Another potential advantage of an exchange-rate peg is that by providing a more stable value of the currency, it might lower risk for foreign investors and thus encourage capital inflows which could stimulate growth. However, as we will see in Section IV, capital inflows may be highly problematic for an emerging market country because they may help encourage a lending boom which eventually weakens the banking sector and helps stimulate a financial crisis.

III.

General Criticisms of Exchange Rate-Pegging There are several criticisms in the literature that are leveled against exchange-rate pegging in both developed and emerging market countries which we will examine first.4 These include the loss of an independent monetary policy, the transmission of shocks from the anchor country, the likelihood of speculative attacks and the potential for weakening the accountability of policymakers to pursue anti-inflationary policies. However, there is an additional criticism of exchange-rate pegs in emerging market countries that does not apply to developed countries: the potential in emerging market countries for an exchange-rate peg to increase financial fragility and the likelihood of a financial crisis. It is this last criticism that we will focus on in the next section which suggests that an exchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries.

Loss of Independent Monetary Policy

One prominent criticism of adopting an exchange-rate peg to control inflation is that it results in the loss of an independent monetary policy for the pegging country. We have already seen that with open capital markets, interest rates in the country pegging its exchange rate are closely linked to those of the anchor country it is tied to, and its money creation is constrained by money growth in the anchor country. A country that has pegged its currency to that of the anchor country therefore loses the ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. For example, if there is a decline in domestic demand specific to the pegging country, say because of a decline in the domestic government's spending or a decline in the demand for exports specific to that country, monetary policy cannot respond by lowering interest rates because these rates are tied to those of the anchor country. The result is that both output and even inflation may fall below desirable levels, with the monetary authorities powerless An excellent additional discussion of these criticisms is contained in Obstfeld and Rogoff (1995).

to stop these movements.

This criticism of exchange-rate pegging may be less relevant for emerging market countries than it is for developed countries. Because many emerging market countries have not developed the political or monetary institutions which result in the ability to use discretionary monetary policy successfully, they may have little to gain from an independent monetary policy but a lot to lose.

Thus, they would be better off by, in effect, adopting the monetary policy of a country like the United States through exchange-rate pegging than in pursuing their own independent policy.

Transmission of Shocks from the Anchor Country

Another criticism of exchange-rate pegging is that shocks in the anchor country will be more easily transmitted to the pegging country, with possible negative consequences. For example, in 1994 concerns about inflationary pressure in the United States led the Federal Reserve to implement a series of increases in the federal funds rate. Although this policy was appropriate and highly successful for the United States, the consequences for Mexico, who had adopted a peg to the dollar as part of its stabilization strategy, were severe. The doubling in short-term U.S. rates from around three to six percent was transmitted immediately to Mexico who found its short-term rates doubling from around ten to twenty percent. This rise in rates was damaging to the balance sheets of both households, nonfinancial business and the banks, and was a factor in provoking the foreign exchange and financial crisis in Mexico which began in December 1994. (See Mishkin, 1996.)

Speculative Attacks

A further criticism of exchange-rate pegging is that, as emphasized in Obstfeld and Rogoff (1995), it leaves countries open to speculative attacks on their currencies. As we have seen in Europe in 1992, Mexico in 1994 and more recently in southeast Asia, it is certainly feasible for governments to maintain their exchange rate peg by raising interest rates sharply, but they do not always have the will to do so. Defending the exchange rate by raising interest rates can be very costly because it involves having to tolerate the resulting rise in unemployment and damage to the balance sheets of financial institutions from these high rates. Once speculators begin to question whether the government's commitment to the exchange-rate peg is strong because of the now high costs to maintain it, they are in effect presented with a one-way bet, where the only way for the value of the currency to go is down. Defense of the currency now requires massive intervention and even higher domestic interest rates.



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