FRBSF Economic Letter
2005-01; January 7, 2005
To Float or Not to Float? Exchange Rate Regimes and Shocks
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the
auspices of the Center
for Pacific Basin Studies within the FRBSF's Economic Research Department.
Many
economists argue that a flexible exchange rate regime is preferable
to a fixed exchange rate regime because it helps to insulate the
domestic economy from adverse external shocks. For example, when
export demand declines, a depreciation makes domestic goods more
competitive abroad, stimulates an offsetting expansion in demand,
and dampens the contraction in domestic economic activity.
In reality,
however, exchange rate depreciations in many emerging market
economies over the past decade typically have been associated
with financial distress and output contractions. Consequently,
recent research has reconsidered the stabilization properties
of a flexible exchange rate regime when exchange rate movements
affect
financial conditions, and these, in turn, influence economic activity. This Economic
Letter summarizes some of the findings of these
studies and their policy prescriptions for the choice of the
exchange rate
regime. Some studies find that, in spite of the adverse impact
of changing exchange rates on financial conditions and aggregate
economic activity, a flexible exchange rate regime is still preferable.
Yet, this is difficult to reconcile with the observation that
many emerging market economies prefer to avoid exchange rate
adjustments.
Other studies explain this behavior by showing how changing exchange
rates can produce severe financial distress that, in turn, leads
to a net loss of wealth. This mechanism explains why emerging
market economies may prefer to keep the exchange rate fixed,
at least
in the short run, to mitigate the costs arising from exchange
rate adjustment.
Balance sheet effects
Episodes of large exchange rate adjustments
in emerging market economies during the 1990s were characterized
by widespread defaults
by domestic firms and output contractions. This led many researchers
to evaluate how financial conditions affect the impact of exchange
rate adjustments on aggregate economic activity. Financial conditions can influence aggregate demand through balance
sheet effects on borrowing and investment expenditure. These
effects occur when the interest rate at which firms borrow
from financial
intermediaries to finance investment depends on the level of
net worth, which is essentially a firm's gross value of assets
net
of liabilities. Firms with a lower net worth tend to finance
a greater share of their investment through debt. Since these
firms
will be more leveraged, they are less likely to meet their loan
obligations in the event of some negative shock to their activity.
Consequently, to compensate for the greater expected likelihood
of default, lenders will charge these firms a higher risk premium.
Therefore, a lower net worth, through an increase in the risk
premium, leads to a higher cost of borrowing that, in turn,
reduces investment.
When
external liabilities are denominated in foreign currencies, as
is the case for almost all emerging market economies, exchange
rate depreciation may have negative balance sheet effects. Since
domestic firms typically earn their revenues in their domestic
currency, depreciation makes these revenues worth less in terms
of foreign currency, thereby reducing their capacity to service
foreign currency debt. The associated reduction in net worth
generates an increase in the risk premium on borrowing that dampens
investment
expenditure and aggregate demand. Therefore, the interaction
of balance sheet effects and foreign currency denomination of liabilities
can lead exchange rate depreciations to be contractionary and
render
flexible exchange rate regimes less attractive.  The question is: Are these balance sheet effects large enough to
make policymakers prefer a fixed exchange rate regime? Céspedes,
Chang, and Velasco (2004) and Gertler, Gilchrist, and Natalucci
(2003) address this question by analyzing the reaction of an emerging
market model economy to an adverse external shock, such as an increase
in the foreign interest rate. These studies conclude that, even
in the presence of balance sheet effects, flexible exchange rates
still provide more output stabilization in response to a negative
external shock. For example, consider the effect of an increase in the foreign
interest rate above the domestic interest rate. Under flexible
exchange rates, this induces a financial outflow and a depreciation
of the domestic currency. With liabilities denominated in foreign
currency, this channel produces a decrease in net worth. However,
there are also positive consequences from the asset side of firms'
balance sheets. Because the depreciation makes domestic goods
relatively cheaper, export revenue rises, creating a positive
impact on net
worth. If this positive effect dominates and net worth rises,
the overall effect of depreciation need not be contractionary. Alternatively, under fixed exchange rates, the central bank must
raise the domestic interest rate to match the increase in the
foreign interest rate so as to prevent the domestic currency
from depreciating.
This interest rate rise leads to a decrease in a firm's net worth
because future revenues are worth less in current value terms.
As net worth shrinks, the risk premium rises, inducing a contraction
in investment spending and output. Therefore, under fixed exchange
rates, balance sheet effects exacerbate the contractionary effects
of an increase in the foreign interest rate on investment, aggregate
demand, and output.
Some stylized facts
Despite these theoretical arguments in favor
of a floating exchange rate policy, many emerging market economies
appear averse to
exchange rate adjustments. Calvo and Reinhart (2002), notably,
report evidence
of widespread fear of large exchange rate adjustment in emerging
market economies. In addition, Hausmann, Panizza, and Stein
(2001) find that this is particularly so for countries that borrow
heavily
abroad in foreign currency, as they are exposed to the potential
for balance sheet deterioration.
Cavallo et al. (2004) find that balance sheet effects are,
in fact, at the root of the output contraction in the aftermath
of an exchange
rate adjustment. As shown in Figure 1, they detect a positive
relation between the severity of output contractions and
an index
of intensity
of balance sheet effects, where the latter is measured by
the product of total real exchange rate (REER) depreciation
and
the ratio of
net foreign currency liabilities to output. In addition,
they observe that many of the recent exchange rate adjustment
episodes
in emerging
market economies have been characterized by exchange rate
overshooting; that is, the degree of exchange rate depreciation
in the short
run was considerably larger than in the long run. Cavallo
et al. (2004) also find that exchange rate overshooting is
greater
the
higher is the ratio of foreign currency debt to GDP, as Figure
2 indicates. Which exchange rate policy?
Cavallo et al. (2004) formulate a model that relates these stylized
facts by recognizing one additional feature of most recent
episodes of exchange rate adjustment in emerging market economies;
specifically,
these countries also experienced a decline in the confidence
of foreign investors that sharply curbed their ability to
borrow from
abroad.
In their model, exchange rate depreciation produces negative
balance sheet effects that interact with the reduced ability to
borrow
abroad, which, in turn, generates the need to reduce external
indebtedness even further. This can be achieved through two channels:
reducing
imports of foreign goods and selling equity claims in domestic
firms to foreign investors. Each channel of adjustment has further
effects. The drop in imports induces a further depreciation of
the exchange rate that results in exchange rate overshooting,
while the sale of domestic assets prompts a decline in domestic
equity
prices (see Aguiar and Gopinath 2005 for evidence on East Asian
countries during the late 1990s). Both effects are stronger when
the exposure to foreign currency liabilities is larger, as any
depreciation creates a greater need to reduce external indebtedness.
In addition, they magnify the costs of exchange rate depreciation:
exchange rate overshooting interacts with sizable foreign currency
liabilities and exacerbates the adverse balance sheet effect
of depreciation on output, while the sale of domestic assets at
a
discount implies a net loss of wealth that permanently affects
domestic consumption.
Preventing exchange rate depreciation avoids the negative balance
sheet effects and lessens the need to sell off domestic equity
assets, but at the cost of making domestic goods less competitive.
This hampers aggregate demand and depresses domestic output.
For this reason, as other studies have concluded, a regime of flexible
exchange rates may in fact dominate in the long run. In the short
run, however, matters can be quite different: in the face of
a
sharp reduction in the ability to borrow externally, keeping
the exchange rate fixed mitigates the disruption caused by the
necessary
sales of domestic equity assets and the resulting loss of wealth,
so that, in this case fixed exchange rates dominate.
 Conclusions
In answer to the question posed in the title, "to float or
not to float," the evidence and the models discussed in this
Economic Letter point to the relevance of foreign currency liabilities
in choosing the appropriate exchange rate policies in response
to adverse external shocks. Specifically, recent research has found
that, even when financial conditions influence aggregate economic
activity, flexible exchange rates can be more desirable than fixed
exchange rates as a tool to deal with adverse external shocks.
However, in emerging market economies these shocks often involve
temporarily reduced access to international financial markets.
Under such scenarios, a policy of flexible exchange rates can lead
to substantial costs. Conversely, a policy of fixed exchange rates
dampens these costs, and, at least in the short run, can be preferred
to an exchange rate adjustment.
Michele Cavallo
Economist
References
Aguiar, Mark, and Gita
Gopinath. 2005. "Fire-sale
FDI and Liquidity Crises." Review of Economics and
Statistics,
forthcoming.
Calvo, Guillermo
A., and Carmen M. Reinhart. 2002. "Fear
of Floating." Quarterly Journal of Economics 117 (May)
pp. 379-408.
Cavallo, Michele, Kate Kisselev, Fabrizio
Perri, and Nouriel Roubini. 2004. "Exchange Rate Overshooting
and the Costs of Floating." Mimeo. New York University.
Céspedes, Luis Felipe, Roberto
Chang, and Andrés
Velasco. 2004. "Balance Sheets and Exchange Rate Policy." American
Economic Review 94 (September) pp. 1183-1193.
Gertler, Mark,
Simon Gilchrist, and Fabio M. Natalucci. 2003. "External
Constraints on Monetary Policy and the Financial Accelerator." NBER
Working Paper no. 10128. http://papers.nber.org/papers/w10128.pdf
Hausmann,
Ricardo, Ugo Panizza, and Ernesto Stein. 2001. "Why
Do Countries Float the Way They Float?" Journal
of Development Economics 66 (December) pp. 387-414.
|
