Journal Issue

3. Impediments to Greater ER Flexibility

Mark Horton, Hossein Samiei, Natan Epstein, and Kevin Ross
Published Date:
May 2016
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Fear of Floating and Related Factors

The challenge of adjusting to greater ER flexibility reflects several factors. These include: (1) the status of development of monetary policy institutions; (2) high ER pass-through to inflation (ERPT); (3) high liability dollarization; (4) concerns with excessive ER volatility; (5) shallow financial markets; and (6) political economy considerations. The first two factors are mainly related to the central bank’s price stability mandate, while the other factors capture possible real costs of greater ER flexibility.

Monetary Policy Institutions and the Need for a Nominal Anchor

Because of the strength of institutions, including central bank independence, policymakers in developing countries may suffer from lack of credibility. Monetary policy may be subordinated to fiscal needs, leading to an excessive reliance on the inflation tax, and more generally, a difficulty to anchor inflation expectations. By serving as a clear, visible anchor, pegging the ER, especially de jure, can help make up for lack of credibility.11

Allowing for greater ER flexibility may be seen as leading to a de-anchoring of inflation expectations and prompt calls for an alternative nominal anchor. This would, in turn, require that policymakers clarify their policy frameworks and strengthen monetary institutions, which can be challenging in the midst of shocks and in the absence of a strong commitment to price stability.

High ER Pass-through (ERPT)

Policymakers in small open economies may be concerned about the potential inflationary effects of fluctuations of the nominal ER. Since the size of these effects depends on the degree of ERPT, policymakers from countries with high pass-through may prefer to limit ER fluctuations. The degree of ERPT is likely closely related to the policy regime and the degree of credibility. Countries with a history of high inflation are more likely to experience high pass-through: firms are more likely to raise prices in the event of a nominal depreciation if they suspect that it reflects excessively accommodative policies.12

Financial Dollarization

Like many developing and emerging market economies, CCA countries display high dollarization of their financial systems and of corporate and sovereign balance sheets. This reflects several factors. First, many EMs are limited in their capacity to borrow in their own domestic currencies and, therefore, accumulate foreign currency debt—the so-called “original sin.”13 In addition, given a history of high and volatile inflation (and financial repression), dollarization of the domestic financial system emerged as a mechanism for protecting domestic savings from the inflation tax. Savings by depositors in dollars contribute to funding for lending to dollars, and FX loans are often at rates lower than domestic currency loans. With a stable currency, this provides incentives to borrow in FX.

Although financial dollarization has advantages—it may help with the development of the domestic financial system and limit capital flight—sharp ER depreciations may drastically raise the domestic currency value of private and public debt. This may result in a large debt overhang, impairing the economy’s capacity to consume and invest and increasing the likelihood of a balance of payments or financial crisis. To forestall these effects, country authorities may try to stabilize ERs. It must be stressed that dollarization is itself endogenous to the ER regime, as greater nominal ER stability often results in higher foreign currency borrowing.

Excessive Volatility and Deviations of the Real Exchange from Its Equilibrium Value

It has long been recognized that floating ER regimes can be characterized by heightened volatility of both nominal and real ERs (for example, Mussa 1986). For example, in a flexible ER regime with integrated financial markets, nominal ERs may be driven not only by fundamentals but also by short-term, speculative capital flows, resulting in greater volatility. With sticky prices and wages, this nominal volatility becomes real ER volatility. High real ER volatility can be costly, discouraging trade in goods and services and long-term capital inflows and reducing overall investment.14

It is unclear, however, whether higher real ER volatility has a negative effect on growth, although there is some evidence that it affects productivity growth at lower levels of financial development.

Shallow and Underdeveloped Financial Markets

Another source of nominal and real ER volatility is the incipient nature of financial markets in developing countries. In shallow financial markets, there may be limited capacity to absorb changes in the demand for FX. Allowing the ER to float freely in these circumstances may therefore result in excessively large changes in the ER, with negative effects. The development of an active money market would also support the effectiveness of central bank monetary operations.

Political Economy Considerations

Political economy factors may also contribute to fear of floating. ER pegs (either de factor or de jure) tend to be associated with overvalued real ERs (Ghosh and others 2010), possibly because external adjustment is much slower under pegs, and overvaluations can endure. If the dominant lobby represents net importers—which is the case in some CCA countries—then there may be a push for pegs as net importers benefit from an appreciated currency. The opposite holds for exporting lobbies. Countries that are more heavily specialized in commodities, for example, oil producers, are more likely to have strong import lobbies, as export industries are not sensitive to ER fluctuations. If exports consist of manufactured products or services, and if these sectors are dominated by powerful or vocal firms, then the opposite may hold. That being said, there may instead be fear of appreciation, and ER flexibility may be asymmetric: appreciating pressures may be resisted while depreciating pressures are accommodated. In the case of remittances, migrant workers may have a similar mindset as exporters—a bias to depreciation to increase the local currency value of their transfers. However, these workers are likely to have limited lobbying power back home.

Another consideration may be a strong view of the public in favor of ER stability as the key objective of the central bank. The population may actually prefer ER stability over price stability if the former is interpreted as a sign of monetary stability, and if the latter is hard to achieve over the short term due to supply side shocks. This is different from the lack of credibility mentioned earlier in that the choice of regime is dictated by local preferences.

CCA Central Bank Communications

Central bank communications and information flows in CCA countries may be an additional impediment to ER flexibility. Greater ER flexibility entails more volatility, risk, and uncertainty. Good communications among all economic stakeholders are important to understand and manage these risks. Credibility of CCA central banks has typically come from long periods of stable ERs rather than from discussing and managing volatility and uncertainty. Central banks may be more comfortable and vested in ER stability.

Additional factors characterize central bank communications in the CCA, included next.

Trust, Independence, and Capacity

  • CCA central banks operate in an environment of relatively low public trust in state institutions, low economic literacy, and limited public debate. Media, think tanks, academic communities, and surveys of public sentiments that foster accountability in other regions are less developed in CCA countries.
  • CCA central banks may feel constraints in communicating openly and transparently. Key stakeholders for central bank communications may be relatively narrower, and central bank communications may not always be aligned with communications by governments or finance and economy ministries.
  • CCA central banks may face capacity constraints in identifying risks, due to insufficient analytical capacity, limited data on economic conditions, and insufficient internal coordination and communications. At the same time, CCA central banks may have strong capacity relative to other local institutions (staff, financial resources, information) and be pulled in to solve problems outside their core areas (for example, advising on restructuring of companies or on public investment projects, or managing or channeling states funds).

Development of Communications Channels

  • Communications channels in CCA countries may not be well developed relative to other regions: press conferences, interviews, and other statements by central bank governors may be infrequent; central bank minutes may not be published; and websites and social media presence may be limited. Central bank bulletins may be limited to factual information, providing little analytical discussion.
  • CCA central banks may communicate more via indirect channels, “behind the scenes” or more in times of pressure. Thus, the public and markets may associate central bank communications with “crises,” so that audiences are conditioned to be nervous when central banks communicate.

Capacity of Other Institutions

  • In some CCA countries, journalists are perceived as having limited training in economics, or reflecting views of their financial benefactors. Newspaper or website circulation may be limited, with few dedicated business or economics publications. National TV may not be a good medium for discussion of complex macroeconomic issues.
  • Market participants in the CCA may benefit from stronger analytical capacity and independence. They may be reluctant to take opposing positions.

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