Exchange Rate Regime for Emerging Markets

Exchange Rate Regimes for Emerging Markets

Diploma Paper Submitted to Professor Harris Dellas, Chair of Applied Macroeconomics,

University of Bern Winter Semester 05/06

By Kilian Widmer 99-117-806

Exchange Rate Regimes for Emerging Markets Table of Contents

I

Table of Contents

Figures: ............................................................................................................ III

Tables: ............................................................................................................. III

1. Introduction.................................................................................................... 1

2. Emerging Markets and Exchange Rate Regimes ............................................ 3

3. Fixed versus Flexible ..................................................................................... 5

3.1 The Case for and against Fixed Exchange Rates............................................................7

3.2 The Case for and against Floating Exchange Rates........................................................9

3.2.1. Inflation Targeting ..............................................................................................10

3.3 Lender of Last Resort..................................................................................................12

3.4 Fiscal Policy ...............................................................................................................13

3.4.1. Fiscal Policy as the Problem................................................................................13

3.4.2. Fiscal Policy as an Instrument .............................................................................15

4. The Theory on the Choice of Exchange Rate Regime .................................. 16

4.1. Optimal Currency Area Criteria .................................................................................17

5. Emerging Market Issues ............................................................................... 21

5.1. Credibility..................................................................................................................22

5.2. Access to International Financial Markets ..................................................................24

5.3. Sudden Stops and Currency Crises .........................................................................25

5.4. Trade Issues ...............................................................................................................27

5.5 Effectiveness of Monetary Policy................................................................................28

5.5.1. Monetary Independence ......................................................................................28

5.5.2. Is Expansive Monetary Policy Contractionary? ...................................................31

5.5.3. Pass Through Issues ............................................................................................32

5.5.5. Wage Indexation .................................................................................................33

5.5.6. Unofficial Dollarization ......................................................................................34

5.5.7. Currency Mismatch.............................................................................................36

5.6. Fear of Floating .........................................................................................................41

6. Development of Institutions ......................................................................... 42

6.1. Financial Institutions..................................................................................................42

6.2. Monetary and Fiscal Institutions ................................................................................46

7. Conclusions.................................................................................................. 51

Exchange Rate Regimes for Emerging Markets Table of Contents

II

Annex............................................................................................................... 53

References:....................................................................................................... 60

Exchange Rate Regimes for Emerging Markets Figures and Tables

III

Figures Figure 1: Emerging Market Economies by Region..................................................................3

Figure 2: Exchange Rate Regimes ..........................................................................................4

Figure 3: Balance Sheets of Currency Boards and Central Banks............................................6

Figure 4: Openness of Fixed Pegs.........................................................................................19

Figure 5: Inflation in Mexico, Chile and Singapore...............................................................30

Figure 6: Development of Debt Securities in Emerging Markets...........................................44

Figure 7: Domestic Debt Securities in Advanced Countries and Emerging Markets��...44

Figure 8: % of Nonperforming Loans in Emerging Markets..................................................45

Figure 9: % of Nonperforming Loans in Advanced Countries and Emerging Markets...........45

Figure 10: Inflation in Emerging Markets .............................................................................47

Figure 11: Public Debt in Emerging Markets ........................................................................49

Figure 12: Emerging Market Sovereign Credit Ratings .........................................................49

Figure 13: Local and Foreign Currency Credit Ratings .........................................................49

Tables Table 1: Foreign Exchange and Derivatives Markets in Emerging Markets...........................43

Table 2: Inflation, Fiscal Balances, and Seigniorage in Emerging Markets............................48

Table 3: Openness of Emerging Market Economies..............................................................53

Table 4: Domestic Debt Securities in Emerging Markets ......................................................54

Table 5: Domestic Debt Securities in Emerging Markets (in % of GDP)...............................55

Table 6: Domestic Debt Securities in Advanced Countries in 2004.......................................56

Table 7: Public Debt in Emerging Markets ...........................................................................57

Table 8: Percentage of Nonperforming Loans in Emerging Markets .....................................58

Table 9: Percentage of Nonperforming Loans in Advanced Countries...................................58

Table 10: Emerging Market Sovereign Credit Ratings ..........................................................59

Table 11: Fear of Floating (Calvo and Reinhart) ...................................................................60

Table 12: Fear of Floating 2002-2005...................................................................................61

Exchange Rate Regimes for Emerging Markets Chapter 1

1

1. Introduction

The choice of exchange rate regime is a topic that has been thoroughly discussed in

economic literature. Reviewing the literature, I find that the debate has almost raised as many

questions as it has delivered answers. The influence of particular exchange rate regimes on the

real economy essentially remains unclear, as empirical evidence is mixed and problems of

reverse causality arise. Likewise, there is no overall consensus on the relative importance of

specific factors influencing the choice of exchange rate regime. However, one indisputable

conclusion that has emerged is that the standard theory on the choice of exchange rate regimes

for industrialized economies does not apply well to emerging markets and developing

countries.

Emerging markets are a very heterogeneous group of economies that differ widely in their

economic features, especially Asian and Latin American economies. However, one fact all

emerging market regions have in common is that they all faced currency and financial crises

in the past decade, indicating that exchange rate regimes in emerging markets are less stable

than in their industrial counterparts. These crises have shifted the focus of economists on

factors and characteristics that are specific to emerging markets and developing countries, or

are of substantially less importance in advanced countries. Most of these factors are linked to

the lower credibility of monetary policies and institutions in emerging markets, making them

more vulnerable to exchange rate variability.

Essentially, an exchange rate regime should set a framework that enables policymakers to

reach their macroeconomic goals and create an environment that is conducive to economic

growth. In the past both fixed and flexible regimes have not succeeded in providing this

framework, documented in the crises of fixed regimes and the high rates of inflation in

flexible regimes. While exchange rate regimes have an effect in altering the characteristics of

an economy, it is basically a country�s characteristics that determine which exchange rate

regime is best suited to the needs of the respective economy. As the characteristics of an

economy change, so does its �optimal� regime (Frankel, 1999). The vast differences among

emerging markets do not allow a generalization of a best solution concerning the choice of

exchange rate regime. However, there are certain general developments among emerging

markets that speak for an increased amount of exchange rate stability or an increased amount

of flexibility.


2

While both fixed and flexible regimes have their virtues and drawbacks, there is no overall

consensus among economists on which is the better solution for emerging market economies.

In recent years there has been a trend among emerging markets towards increased flexibility,

and currently the majority of economies have floating regimes installed (Hakura, 2005).

However, their actual exchange rate behaviour indicates that many countries are deliberately

limiting swings in their exchange rate, thereby often resembling the behaviour of fixed

regimes (Calvo and Reinhart, 2002).

The focus of this paper is to give an overview of the advantages of fixed and flexible

exchange rate regimes, to document characteristics that are specific to emerging markets, and

to show the implications of these characteristics on the choice of exchange rate regime and the

actual behaviour of exchange rates.

The paper is structured as follows: The second chapter gives an overview of the group of

emerging market economies and different exchange rate regimes. I discuss the basic

theoretical advantages fixed and flexible exchange rate regimes entail in chapter 3, while

chapter 4 takes a look at the standard theory on the choice of exchange rate regime. The fifth

chapter analyses specific factors that are prevalent in most emerging market economies and

how they influence the behaviour of exchange rates and monetary policy. The development of

institutions in emerging markets is the topic of the sixth chapter, while the concluding chapter

touches on the implications of my findings.


3

2. Emerging Markets and Exchange Rate Regimes Empirical researches in emerging markets analysing the factors that have an influence on the

choice of a specific exchange rate regime, and conversely the influence of certain exchange

rate regimes on real macroeconomic variables, depend on the choice of exchange rate regime

classification as well as the definition of emerging market economies.

There are several different definitions of emerging market economies that differ slightly

from each other, mainly in the number of economies included, but essentially all definitions

are grouped around the same core of economies. I will be using the group of 25 emerging

market economies (Figure 1) presented in Rogoff et al. (2003), which are identical to the

group of economies in the Morgan Stanley Capital International (MSCI) index.

Figure 1: Emerging Market Economies by Region

Latin America Argentina Brazil Chile Colombia Mexico Peru Venezuela Asia China India Indonesia Korea Malaysia Pakistan Philippines Thailand Europe, Middle East, and Africa (EMEA) Czech Republic Egypt Hungary Israel Jordan Morocco Poland Russia South Africa Turkey source: Rogoff et al. (2003)

Regarding the classification of exchange rate regimes, there seems to be no consensus

among economists on a single, correct classification scheme. A problem that arises is that the

behaviour of exchange rates (de facto) often does not correspond with the announced regime

(de jure) in place. While exchange rate classifications in the past were based on the

announced regime, recent classifications have focused on the actual behaviour of regimes1.

Other principal differences among exchange rate classifications arise due to the different

number of individual regimes within classifications and the usage of different methodologies,

with some economists also considering the behaviour of, among others, parallel exchange

rates, interest rates, and the level of reserves. Frankel (2003) shows that the correlations

among different de facto regime classifications are not very high.

1 See, for example, Reinhart and Rogoff (2004).


4

Figure 2: Exchange Rate Regimes

Exchange Rate Regimesa (de facto)

Dollarization and monetary union Currency board Fixed peg China* Jordan* Malaysia Venezuela Morocco Peg within bands Hungary*+ Crawling peg Crawling bands Managed floating Argentina Czech Rep.+ Egypt India Indonesia Pakistan Peru+ Russia Thailand+ Independently floating Brazil+ Chile+ Colombia+ Israel*+ Korea+

Mexico+ Philippines+ Poland+ South

Africa+ Turkey

a. As of December 31, 2004. * The regime operating de facto in the country is different from its de jure regime. + Monetary policy of inflation targeting. source: IMF

The exchange rate regime classification of the IMF (Figure 2) consists of 8 different

regimes. The regimes are ordered by the rigidness of their exchange rate. The regimes at the

top display the least amount of exchange rate variability, while descending in the order of

regimes is associated with a gain of exchange rate flexibility. Exchange rate regimes are often

grouped into three general categories of regimes: fixed, intermediate, and floating. Hard pegs,

i.e. dollarized economies, monetary unions and currency boards, belong to the fixed category.

Pegs within bands, crawling pegs, and crawling bands are considered intermediate regimes, while

managed and free floats would make up the floating category. Assigning fixed pegs to a group is

the most difficult task, as they could be assigned to either the fixed or intermediate category.

Reviewing the classification of the emerging markets, it is obvious that the majority have

decided for floating regimes, while at the other end, no hard pegs are in place (anymore).

However, empirical evidence indicates that emerging markets float in a different way than

advanced countries by trying to limit their exchange rate swings, thereby often resembling the

behaviour of less flexible regimes2.

In the following, I will not refer to specific exchange rate regimes, but rather discuss the

advantages of fixed and flexible regimes as well as conditions and developments favoring fixed or

flexible exchange rates and/or increased stability or flexibility.

2 See Calvo and Reinhart (2002) and Hausmann et al. (2000).


5

3. Fixed versus Flexible One of the principle insights of the Mundell-Fleming model3, and macroeconomic theory in

general, is the hypothesis of the impossible trinity: a country cannot simultaneously have a

fixed exchange rate, unrestricted capital mobility, and an independent monetary policy. It

must choose two out of three. Given that the choice of capital controls is rarely chosen, the

choice effectively boils down to a trade-off between exchange rate stability and flexibility

provided by an independent monetary and exchange rate policy. However, as Frankel (1999)

notes, the implications of the impossible trinity do not compel an economy to choose between

stability and flexibility per se. Rather an economy is free to opt for an in-between

(intermediate) solution, for example by limiting the magnitude of exchange rate swings or

defending an exchange rate peg only to the extent that it does not interfere with other

macroeconomic objectives. The advantages of stability decrease with the amount of flexibility

a regime exhibits, while in turn the advantages of flexibility decrease with the rigidity of the

exchange rate. Unless otherwise noted, I will be assuming high capital mobility without

capital controls throughout my paper.

Absolutely fixed exchange rate regimes or hard pegs, i.e. currency unions, unilateral

currency unions (dollarization), and to a certain extent currency boards (depending on their

reserve requirements) guarantee a fixed exchange rate through the adoption or creation of a

foreign currency as legal tender, or in the case of currency boards through a conversion rate

that is fixed by law. An exit from the regime and the exchange rate parity is associated with

large economic costs and political difficulties, so that the public views a (voluntary) departure

as highly unlikely (Ghosh et al., 2002). Hard pegs are based on a simple monetary policy rule:

changes in the monetary base are determined by the balance of payments account

(Williamson, 1995, Schuler, 2000). A deficit contracts the money supply, while a surplus

enlarges it. Adopting a hard peg means that an economy loses its ability to create money

(monetary unions) or it is severely constrained (currency boards) and that domestic interest

rates are tied to the rates in the anchor country through interest rate parity. Thus, an economy

must sacrifice its monetary sovereignty and accept the monetary policy of the country it

pegged its currency to in order to fix its exchange rate.

3 Mundell (1963) and Fleming (1962)


6

Figure 3: Balance Sheets of Currency Boards and Central Banks

Central Bank Assets Liabilities

Foreign reserves Cash Deposits of noncommercial banks

Domestic assets/credit (government debt)

Net worth source: Williamson (1995)

Intermediate regimes provide a solution for economies that are unwilling to totally give up

on an independent monetary policy but are equally unwilling to face large exchange rate

swings. As mentioned above an economy can choose the degree of flexibility/stability best

suited to its needs. In this context a regime that is/was often chosen is a fixed but adjustable

exchange rate regime (FBAR). In contrast to hard pegs, where the monetary authority only

has foreign reserves at its disposal, or no reserves at all in the case of dollarization, under a

FBAR the central bank has a foreign and a domestic component to its reserves (Figure 3),

which allows the central bank to manage the exchange rate. When the fixed exchange rate

comes under pressure of depreciating (appreciating), the central bank can sell (buy) foreign

reserves to support the exchange rate. However, the ability to defend the exchange rate is

limited to the amount of foreign reserves an economy possesses. In the case of strong market

pressures or fundamental macroeconomic disequilibria, FBARs have an escape clause

allowing them to adjust the exchange rate (Ghosh et al., 2002). This option, however, should

only be chosen in emergency cases, as frequent exchange rate readjustments undermine the

credibility of the exchange rate peg (Corden, 2002).

Under a purely floating exchange rate the domestic monetary authority is indifferent to

changes of the exchange rate. Having no preference for a particular exchange rate, there is no

need for the central bank to intervene in the foreign exchange market and, hence, there is

theoretically no need for a large stock of foreign reserves (Ghosh et al., 2002). However, as

many economists note, pure floaters exist only in economic theory. Thus, even under floating

exchange rate regimes monetary policy is diverted to some extent to limit excessive exchange

rate fluctuations. However, there is no particular commitment to a certain exchange rate and

therefore the exchange rate is much less of a constraint to monetary policy than under other

regimes.

Currency board Assets Liabilities Foreign reserves Cash Net worth source: Williamson (1995)


7

3.1 The Case for and against Fixed Exchange Rates In the ensuing brief discussion of the advantages and the drawbacks of exchange rate

regimes, I will focus on the polar extremes of absolutely fixed and purely floating exchange

rates.

One of the biggest advantages of fixed exchange rate regimes is their alleged ability to fight

inflation. Fixing the exchange rate has been a way of quickly reducing inflation in countries with

high inflation and a chronic inflation problem, such as Ecuador and Argentina. Several empirical

studies have shown that (high) inflation is costly and impairs the economic growth of an economy.

Adopting an ultimately fixed exchange rate regime provides a credible nominal anchor for

monetary policy. By doing so, an economy imports the monetary policy of the country it pegged its

currency to as well as its credible commitment to price stability. As a corollary, inflation

expectations are lowered to a level that is comparable with the anchor economy (Mishkin, 1999).

The monetary rules of a hard peg preclude the conduct of an independent monetary policy, and

consequently an inflationary policy as well as the monetization of fiscal deficits. Thus, by fixing

the exchange rate to a low inflation, hard currency country an economy eliminates discretion,

establishes monetary discipline, and ultimately will lower inflation expectations (Corden, 2002).

Additionally a fixed exchange rate is a transparent and simple nominal anchor in comparison with

other possibilities. It can be easily observed and verified by the public and thus will help to reduce

uncertainty, which ultimately enhances the credibility towards price stability (Frankel, 2003).

A further argument of advocates of fixed exchange rates is that fixed exchange rate regimes have

a positive effect on trade. Short and middle-term exchange rate volatility often cannot be

explained by economic fundamentals, with excessive volatility posing a threat for the trade sector

of an economy (Corden, 2002). Hard pegs guarantee a fixed exchange rate, and thus minimize the

exchange rate risk. As a result, transaction costs will fall and trade will be promoted as well as

investment. In general, the harder the peg, and thus the less frequent exchange rate adjustments

are, the greater the gains from trade will be. Naturally currency unions will create the greatest

benefits, due to the elimination of the exchange rate and transaction costs. In a study that has

received much attention due to its astonishing results, Frankel and Rose (2002), using data for

more than 180 countries from 1970 to 1995, find that a common currency triples trade with close

trading partners. They also find that enhanced trade will lead to closer economic and financial

integration, especially with the anchor country, promote openness to trade and ultimately lead to

higher economic growth. Using a meta-analysis to examine the effect of currency unions on trade

from thirty-four empirical studies, Rose (2004) finds a smaller effect of currency unions on trade


8

than previously, ranging from over 30% up to 90%, but the results nonetheless indicate a strong

positive relationship between currency unions and trade. While empirical evidence suggests that

currency unions enhance trade, the (negative) link between exchange rate volatility and trade is

less clear-cut. A number of studies find no statistically significant relationship4 and in the cases

where studies do find a relationship, the effect is relatively small, with the consensus estimate

being that the total elimination of exchange rate volatility would lead to a roughly 10% increase of

trade in industrialized countries (U.K. Treasury, 2003). However, it does seem sensible that

countries with intensive trade ties or countries wishing to intensify their trade ties would favour a

fixed exchange rate.

A third advantage often mentioned in economic literature is that hard pegs will lower real

interest rates (Berg and Borensztein, 2000). By fixing the exchange rate the expected likelihood of

depreciations is reduced and with it the currency risk component of domestic interest rates. Lower

interest rates together with lower inflation would promote investment, lead to an expansion and

deepening of the financial sector and would also reduce debt-servicing costs of the government.

With the currency risk component depending on the likelihood of a future devaluation, here too

the general rule of the harder the peg the greater the benefit applies. Advocates of fixed exchange

rates cite the example of Panama, a dollarized economy, where the nominal interest rates and

interest rate spreads have been persistently lower than in most other Latin American countries,

while real interest rates have been low and steady (Schuler, 2000).

The inability to pursue an independent monetary policy is the principal drawback of fixed

exchange rate regimes, as its makes them vulnerable to negative shocks.5 Under fixed exchange

rates and complete capital mobility, expansionary monetary policy has no effect on the economy.

The additional liquidity created leaves the economy via a balance of payments deficit. In the case

of a real negative shock, which will require an adjustment of the real exchange rate, the effects of

an economic downturn cannot be corrected by a depreciation of the currency. As a consequence

the downward adjustment must be borne by wages and prices, which inevitably leads to a higher

and longer economic contraction than under a flexible exchange rate regime (Frankel, 1999).

Furthermore, the imported monetary policy can be the source of disturbance in the form of an

asymmetric shock. If the fixed country and the anchor country are at quite different positions in

their business cycles, then the fixed economy could face an increase of interest rates although a

decline would be required (Goldstein, 2002). In addition, the common monetary policy has the

4 See, for example, Clark et al. (2004) 5 Based on the realistic assumption that nominal wages and prices are sluggish and somewhat inflexible downwards. In the case of a positive shock the outcome does not depend on the exchange rate regime (Corden (2002).


9

effect that the fixed economy cannot insulate itself from shocks to the anchor economy (Mishkin,

1999).

A second disadvantage is the danger of the fixed exchange rate becoming misaligned and the

difficulties associated with restoring an exchange rate that corresponds to the economic

fundamentals (Calvo and Mishkin, 2003). Recent experiences of countries adopting a hard peg,

among others Ecuador, Argentina and Estonia, show that they experienced significant real

appreciation in the first years of implementation, due to higher inflation than in the anchor

economy6. A correction of the real exchange rate would call for a decline in nominal prices and

wages or a lower rate of inflation than in the anchor economy, both of which, if feasible at all,

would put a strain on economic growth. Thus, misalignment problems are more of a concern for

countries with low flexibility in wages and prices. An additional problem is those large exchange

rate misalignments will inevitably increase the chances of a speculative attack (Ghosh et al.,

2002). Using taxes and imports could function as a substitute for wages and prices to achieve

adjustment of the real exchange rate. However, fiscal institutions in most emerging markets are

probably not up to the task (Calvo and Mishkin, 2003).

An issue that concerns hard pegs to a lesser extent but merits consideration nonetheless is the

susceptibility of fixed regimes with a less credible commitment to a fixed exchange rate, i.e.

intermediate regimes, to speculative attacks on their domestic currency, as episodes in the last

decade have shown (Mishkin, 1999, Corden, 2002). A speculative attack challenges a country�s

commitment to the fixed exchange rate. A country can defend its exchange rate by selling foreign

exchange out of its reserves or by raising the interest rate. However, foreign reserves are limited

and raising interest rates has adverse effects on the economy and especially on the banking sector,

so that an economy might see itself forced to devalue its currency. Empirical evidence indicates

that in emerging market economies rigid regimes have had a higher incidence of banking and

currency crises (Rogoff et al., 2003).

3.2 The Case for and against Floating Exchange Rates The main advantage of floating exchange rate regimes is the principal drawback of fixed

regimes, namely the ability to pursue an independent monetary policy suited to the needs of the

domestic economy. In contrast to fixed regimes, interest rates can be set independently, at least in

theory. Furthermore, flexible exchange rates provide better insulation from negative external and

real shocks, due to the fact that the nominal exchange rate is quicker to respond than domestic

6 See Ghosh, Gulde and Wolf (1998, 2002) and Lopez (2002).


10

prices and wages, for any given shock (Corden, 2002). Exchange rate flexibility allows an

economy to respond to a negative external/real shock by increasing the monetary base, leading to

a depreciation of the domestic currency, which will provide a stimulus for the domestic economy.

While these measures probably will not be able to avoid a recession, it would be shorter and less

pronounced than under fixed exchange rates (Frankel, 1999).

A second similar advantage is that even when the economy does not pursue a discretionary

policy, floating exchange rates provide an automatic stabilizer for an economy against shocks

affecting the terms of trade (Frankel, 2003). If the international demand for a country�s products

falls, so will its currency. In turn, a depreciated currency will help compensate for the fall in

international demand.

Floating regimes often entail large exchange rate swings, which cause the exchange rate risk and

transaction costs to rise, and thereby discourage trade and investment. But, as Corden (2002)

explains, smoothing the exchange rate is not always the proper decision. If excessive exchange

rate volatility is caused by changes and developments of the economic fundamentals than

exchange rate swings are �justified� and should be tolerated. However, if changing market

expectations and herd behaviour by investors/speculators rather than economic fundamentals are

the cause for volatility in the exchange rate, which would appear to be the majority of cases, than

by adopting a regime of fixed exchange rates one would alter market expectations and thus would

increase the stability of the system. In contrast, a flexible exchange rates regime would merely

translate exchange rate volatility into interest rate volatility, which would not be a significant

improvement from a macroeconomic point of view (Corden, 2002).

Fixed exchange rate regimes seem to have a slight edge against flexible regimes regarding price

stability. In regimes with flexible rates the exchange rate cannot serve as a nominal anchor.

Instead the most popular (and successful) choice is to define an inflation target as the nominal

anchor. In contrast to hard pegs, under inflation targeting the possibilities of an inflationary

monetary policy and monetization of fiscal deficits cannot be totally ruled out, which is a

disadvantage, especially in many emerging market economies with their histories of monetary and

fiscal mismanagement. An additional factor speaking for exchange rate pegs is that they are

somewhat easier to monitor and verify than inflation targets (Corden, 2002).

3.2.1. Inflation Targeting Adopting a flexible exchange rate regime narrows the choice of possible nominal anchors

for monetary policy. To be more precise, there are basically two possibilities: a monetary


11

target or an inflation target. Among emerging markets the latter has gained popularity and is

to date associated with 13 countries (Figure 2), notably all freely floating regimes except for

Turkey.

Mishkin (2000, p.1) defines the 5 main elements of an inflation targeting monetary policy

strategy as follows: �1) The public announcement of medium-term numerical targets for

inflation; 2) an institutional commitment to price stability as the primary goal of monetary

policy, to which other goals are subordinated; 3) an information inclusive strategy in which

many variables, and not just monetary aggregates or the exchange rate, are used for deciding

the setting of policy instruments; 4) increased transparency of the monetary policy strategy

through communication with the public and the markets about the plans, objectives, and

decisions of the monetary authorities; and 5) increased accountability of the central bank for

attaining its inflation objectives.�

The main issue of monetary policy under floating exchange rates is the commitment to price

stability. Under inflation targeting, the monetary authority seeks to achieve the predefined level of

inflation by varying the short-term interest rates. A specific feature of inflation targeting that helps

to achieve price stability is its simplicity and observability. Assisted by a good communication

policy, monetary policy becomes comprehensible and transparent for a broad public, as they can

easily track the monetary authority�s success. However, for the commitment to price stability to

be successful an independent central bank is necessary, which is not constrained by fiscal or

government considerations and is autonomously in charge of monetary policy instruments

(Masson et al., 1997). While price stability is the overriding policy objective, inflation

targeting allows enough discretion to deal with other objectives, such as limiting excessive

exchange rate swings and reducing output volatility (Mishkin, 2004). Inflation targeting

undoubtedly has its virtues, but it also has its drawbacks. A problem in the conduct of inflation

targeting is that inflation is not easily controlled by the central bank. Moreover, economies

starting from a high level of inflation will experience much more difficulties lowering and

subsequently stabilizing inflation, suggesting that inflation targeting should be implemented after

some successful disinflation (Masson et al., 1997). A second difficulty arises due to the varying

time lags from the adjustment of the interest rate to the subsequent effect it has on the inflation

rate (Corden, 2002). Thus, short-term variations from the target can occur even in the case of

proper policy implementation. In the long-term though, short-term variations (caused by time

lags) alone should not endanger a well-conducted inflation targeting policy.

Skeptics, such as Masson et al. (1997), doubt that some emerging markets have the ability and

willingness to conduct a successful inflation targeting policy. Masson et al. (1997) see the

relatively high income from seigniorage as a manifestation of fiscal dominance and, hence,


12

lacking independence of central banks. Moreover, the authors argue that there seems to be no

consensus that low inflation should be the overriding objective of monetary policy in many

developing countries and emerging markets. High initial rates of inflation and fragile financial

systems are viewed as a serious impediment to a successful implementation and conduct of

inflation targeting. However, the authors also find that a strengthening of institutions may turn

inflation targeting into an attractive option for some developing countries and emerging markets

in the future.

3.3 Lender of Last Resort Among economists there seems to be no overall consensus on whether the lacking lender of last

resort (LOLR) capability of fixed exchange rate regimes is actually an advantage or a

disadvantage. As is generally known, hard peg regimes cannot independently set their money

supply. This facts turns out to be a double-edged sword. While this helps in preventing inflation, it

may be harmful for financial stability, since extended domestic credit cannot be provided in times

of crisis. In this context, Larrain and Velasco (2001, p32) suggest: �The price of low inflation may

be endemic financial instability.�

Proponents of flexible regimes stress the importance of bail-outs in the case of bank runs and

financial turmoil, in order to prevent a full-fledged financial crisis from happening. Moreover,

they believe that the loss of LOLR function may increase financial instability by augmenting the

probability of a banking crisis in countries with weak institutions (Volbert and Loef, 2002).

On the other hand, advocates of fixed regimes believe that the importance of the lender of last

resort function under flexible exchange rates is overestimated (Calvo and Mishkin, 2003, Lopez,

2002). They doubt that emerging market central banks can perform the LOLR ability as well as

their counterparts in industrialized economies for 2 main reasons. The first is that most emerging

markets do not have sufficient foreign reserves (Salvatore, 2002), and more importantly second,

most monetary institutions lack the required credibility to be an efficient lender of last resort. In

an industrialized country the central bank can issue excess liquidity and inject it into the frail

banking system. Due to the credibility of the central bank, the additional money supply is believed

to be temporary and will be withdrawn when the time is ripe. In contrast, in developing countries

with past inflation problems the liquidity infusion is not believed to be temporary, which in turn

raises inflation and depreciation expectations, ultimately exacerbating, rather than easing, the

already critical situation (Mishkin, 1999).

Another line of thought is that by depriving the central bank of its LOLR ability, fixed exchange

rate regimes can avoid or at lest reduce moral hazard problems such as excessive risk taking by

the banks (Lopez, 2002). As a result, the chances that a situation of financial turmoil arises


13

decline, thereby lessening the need for a LOLR altogether. In case that a financial crisis does

arise, the LOLR ability could be performed by commercial banks. Advocates of hard pegs

contend that they will lead to higher financial integration and consequently result in a higher

number of international banks. Their argument is that in the event of a bank run, it is assumable

that foreign banks would bail out their local branches (Larrain and Velasco, 2001). However,

if this is sufficient to stabilize the financial sector is arguable.

Contingent credit lines, rigorous reserve requirements for domestic commercial banks, and

international borrowing are the other main possibilities for economies with fixed exchange rates

to deal with situations of financial instability. But compared with the possibility of money

creation, these alternatives appear to be inferior due to the different drawbacks each entail, such as

higher costs, questionable availability, possibly insufficient amounts of credit, and time lags

(Goldstein, 2002).

Ultimately, it seems that the ability to conduct an effective lender of last resort function under

flexible exchange rates depends on the credibility and the quality of the involved institutions

(Calvo and Mishkin, 2003). Thus, only if emerging market central banks have the required

credibility can the LOLR function be an advantage for flexible regimes.

3.4 Fiscal Policy In the context of exchange rate regimes fiscal policy can take more than one role. While fiscal

policy can be used as a government instrument to stabilize the economy, it can also be a source of

disturbance when the fiscal budget gets out of hand.

3.4.1. Fiscal Policy as the Problem A recurring reason for exchange rate and financial instability among emerging markets in the

past, especially in Latin America, has been the prevalence of fiscal dominance, where �the fiscal

deficit determines the money growth rate, and the money growth rate determines the rate of

inflation of domestic wages and prices� (Corden, 2002, p.109). A thing that fixed exchange rate

regimes and flexible regimes under inflation targeting have in common is that both regimes are

not sustainable with large fiscal deficits (Mishkin, 2000). However, unsound fiscal policies pose a

bigger threat to fixed regimes. While under flexible regimes the inflation target cannot be

achieved, thereby nagging on the credibility of monetary institutions, the exchange rate at least

provides a certain amount of flexibility to deal with the situation. Whereas under fixed exchange

rates, large fiscal deficits jeopardize the viability of the peg. Continuous high fiscal deficits will

lead ceteris paribus to a deterioration of the current account balance, which will steadily increase

the borrowing costs for the domestic economy or force it to monetize its deficits (Corden, 2002).


14

In order to correct the situation the fixed exchange rate must be given up and a more flexible

regime must be installed to reduce the fiscal deficit.

Conventional wisdom has it that fixed exchange rates are better suited to generate fiscal

discipline. Under hard pegs the possibility of monetization of fiscal deficits is ruled out. Instead

foreign reserves must be used to compensate a fiscal deficit. Foreign reserves are limited, and a

lower level could jeopardize the sustainability of the fixed exchange rate. A collapse of the peg

would entail large economic and political costs and surely put an end to the reign of the

policymakers in charge. Thus, one would assume that policymakers, for their own sake, take a

prudent approach to fiscal expenditure (Larrain and Velasco, 2001). However, funding of fiscal

deficits must not affect foreign reserves. Deficits also can be financed through government

issuance of public bonds. Thus, a hard exchange rate peg does not rule out the possibility of a

large fiscal deficit. The example of Argentina, which ultimately defaulted on its debt, proves

evidence that hard pegs are by far not a guarantee for solid fiscal policies (Calvo and Mishkin,

2003).

According to proponents of flexible rates �the combination of a flexible exchange rate and

capital mobility provides the most effective form of discipline� (Corden 2002, p.113). Tornell

and Velasco (2000) argue that key difference between fixed and flexible regime is in the

intertemporal distribution of the costs of imprudent fiscal behaviour. In contrast to fixed

exchange rate regimes, lax fiscal policies under flexible regimes have an immediate impact on

the economy by altering the exchange rate and the price level. These costs must be taken into

consideration by the policymakers in charge, giving them an incentive to balance the budget.

Alternatively under fixed rates, lax fiscal policies affect the level of debt and/or foreign

reserves, which effectively hide the costs from the public and push them into the future. It is

only when the amount of debt or reserves reaches a critical level, which questions the

sustainability of the peg, that the effective costs are borne. Thus, considering the relative short

average duration of pegs, as well as the political instability in many emerging market

economies, the effective costs of fiscal profligacy under fixed exchange rates might have to borne

by the next generation of policymakers, thereby providing little incentive for fiscal discipline for

the present generation.

The empirical evidence regarding the effect of exchange rate regimes on fiscal discipline is

mixed.7 However, reviewing the empirical results, which point in both directions, the

conclusions drawn by the IMF (2001, p143) seem to be the most instructive from my point of

view. �History points to episodes of significant loosening of fiscal policies under currency

7 See, for example, Tornell and Velasco (2000) for a �flexible point of view� or Ghosh, Gulde, and Wolf (1998) for a �fixed point of view�.


15

boards, central bank independence, and partial and even full dollarization; moreover,

significant reductions in fiscal deficits in several countries that adopted inflation targeting in

recent years are yet to be seen. This suggests that monetary (exchange rate) arrangements per

se have only limited power to fix �real� problems arising from a fiscal regime inconsistent

with the goal of price stability.�

3.4.2. Fiscal Policy as an Instrument While fixed exchange rate regimes do not possess the ability to use monetary policy as an

instrument for macroeconomic purposes, they are still left with an instrument at their disposal,

namely fiscal policy. A successful active fiscal policy provides fixed exchange rate regimes with

an instrument to deal with negative shocks and resulting economic downturns, thereby moderating

their principal weakness (Corden, 2002).

However, fiscal policy is not a replacement for monetary policy. The main distinction between

the 2 policies is that: �Fiscal policy is financing while exchange rate depreciation is adjustment�

(Corden, 2002, p.98). A successful fiscal policy used as an instrument to stabilize the economy

requires the government budget to be balanced in the long-term, otherwise the fiscal deficit will

become a burden to the economy. This means that increases in public spending will eventually

have to be reversed and, hence, can only be a temporary stimulus to the economy. Thus, fiscal

measures do not lead to a new equilibrium as in the case of monetary/exchange rate policy, but

they can provide temporary relief from negative shocks (Corden, 2002).

There are a number of difficulties that arise when trying to use fiscal policy as a countercyclical

instrument in fixed exchange rate regimes. First, assuming that fiscal policy is primarily

implemented countercyclical, an economy choosing to expand fiscal expenditures must be able to

acquire fiscal surpluses in times of economic prosperity in order to budget its balance. However,

as only few emerging market economies have been able to record fiscal surpluses in recent years

(table 2) the option of fiscal expansion should be regarded with caution (Corden, 2002). Second,

emerging market economies with high initial levels of public debt (table 7) will probably be not

willing to deliberately expand public spending. The disadvantages, such as an increase of the

borrowing costs, and concerns over inflationary finance as well as the sustainability of the

exchange rate peg, could weigh too heavy (Goldstein, 2002). Third, even if an economy can

produce fiscal surpluses and has a strong debt position, the implementation of an anticyclical

fiscal policy might fail due to the reluctance of politicians. In an economic downturn most

politicians tend to lower fiscal expenditure, convincing them to do the opposite will surely not be

accepted unanimously (Corden, 2002).


16

Countercylical fiscal policy can temporarily weaken the effects of a recession, which would

speak in favour of fixed exchange rates. But the conditions for a successful implementation do not

seem to coincide with the characteristics of most emerging market economies, implicating that

most emerging markets are not able to deliberately use fiscal policy as an instrument.

4. The Theory on the Choice of Exchange Rate Regime After giving a brief overview on the principal advantages and drawbacks of fixed and

flexible regimes, in this section I focus on country characteristics that favour either flexibility

or stability. In the following discussion of specific criteria and characteristics, conclusions that

are drawn will be based solely on the particular characteristic in focus. Unless otherwise noted, I

will always be assuming that other factors will remain equal.

When forming a decision on the choice of an exchange rate regime it is necessary to view the

whole picture and not to focus on particular country characteristics. A country�s characteristics

primarily dictate if the advantages of a fixed or a floating regime will prevail. In every country

there will be certain factors that speak for and against the adoption of a certain exchange rate

regime, and not everywhere will the same factors be of equal importance. Thus, in the debate on

the choice of exchange rate regime one size does not fit all (Calvo and Mishkin, 2003).

Furthermore, policymakers should be aware that country characteristics are subject to changes

over time, so that the ideal regime for today need not be the ideal regime for tomorrow (Frankel

1999). Additionally, countries should verify their ability to adopt a particular regime, notably the

implementation of a hard peg, i.e. dollarization or a currency board, requires a high stock of

foreign reserves (Goldstein, 2002). Last but not least, besides all the economic, political, and

geographical criteria involved in such a decision, one should not forget to consider the possibly

most important factor of all, namely the public�s will. Even the �optimal� exchange rate regime is

doomed to fail if it does not have the public�s backing and approval.

Economic literature states a vast number of criteria that influence the choice of exchange rate

regime. A traditional criterion that is usually mentioned first in the debate of fixed-versus-floating

is the nature of shocks. According to the Mundell-Fleming framework an economy that

predominantly encounters domestic nominal disturbances is better off adopting some sort of fixed

regime. The rigid nominal exchange rate prevents monetary shocks from having real

consequences. On the contrary, if real and/or external shocks are the main cause of concern for an

economy, then a floating regime seems to be the better choice. The required change in relative


17

prices can be achieved more rapidly by adjusting the nominal exchange rate, thereby limiting the

negative effects on the real economy.

Thus, following the Mundell-Fleming approach, one would expect to see countries, which are

subject to large real shocks to have some sort of flexible regime in place. Furthermore, the

observed increase of capital mobility in recent years (IMF, 2005a) can be viewed as an indicator

that the significance of real shocks is growing. But, contrary to economic theory empirical

evidence is less clear-cut. Hausmann et al. (1999) refer to a number of studies that find that

increased terms of trade variability is associated with a higher probability of adopting a fixed

exchange rate. They see the reason for this behaviour in the deeper financial markets that fixed

exchange rate regimes allegedly provide.8 On the other hand, findings by Broda (2003, 2004) and

Edwards and Levy-Yeyati (2003) support the conventional view that negative real shocks have a

larger impact on the output of fixed exchange rate regimes.9 Additionally the authors show the

presence of asymmetries in price behaviour (downward nominal inflexibility), slower real

exchange adjustment under pegs, and that terms-of-trade disturbances account for a higher extent

of real GDP fluctuations in developing countries under pegs (33%) than under floats (15%).

4.1. Optimal Currency Area Criteria

A further traditional approach that takes many relevant country characteristics into account is the

theory of Optimal Currency Areas (OCA) developed by Mundell (1961) and McKinnon (1963).

The OCA theory focuses on a country�s geographical and trade features and provides a framework

to evaluate which countries/regions are best suited to share a common currency and a common

monetary policy. Frankel (1999, p.14) defines an OCA as �a region that is neither so small and

open that it would be better off pegging its currency to a neighbor, nor so large that it would be

better off splitting into subregions with different currencies.� At the heart of the OCA approach is

the insight that the benefits of a fixed exchange rate increase the more 2 countries trade with each

other. The principal reason speaking against the realization of an OCA is its vulnerability to

asymmetric shocks. But even in the presence of asymmetric shocks there are factors that can

mitigate their adverse effects, so that it might still be beneficial for an economy to adopt a fixed

exchange rate. In the following, I will give an overview of the OCA criteria and how they

influence the choice of exchange rate regime.

8 Hausmann et al. (1999, p8) argue that: �fixed exchange rate regimes should result in deeper financial markets, which should be particularly important in economies facing important terms of trade shocks.� 9 Broda (2004) focusing on developing countries, finds that a 10% fall in the terms of trade reduces real GDP by 1.9% in pegs and by 0.2% in floats, while Edwards and Levy-Yeyati studying a sample of 183 countries find a real GDP reduction of 0.4% for floats and 0.8% for pegs.


18

Openness and size: A crucial role in the choice of regime plays the degree of openness to trade,

which can be interpreted as a measure of economic integration (Frankel, 2003), a country exhibits.

There are principally three ways that openness directly affects the choice of exchange rate regime.

First, the higher the degree of income that an economy earns through trade, the larger will be the

adverse effects resulting from exchange rate variability (Corden, 2002). Thus, open countries

seeking to stabilize their output should adopt some form of fixed exchange rate regime. Second,

since international trade between developing and developed countries is principally invoiced in

the stronger currency (McKinnon, 1999, Goldberg and Tille, 2004), nominal wages and prices in a

very open economy are likely to be denominated in a foreign currency or to be linked to the

exchange rate (Corden, 2002). Currency substitution and/or indexation impede the effectiveness

of a discretionary monetary policy and thereby strengthen the case for fixed exchange rates10.

Third, the more open an economy is, the less it needs a flexible exchange rate as a shock absorber

(Corden, 2002). An open economy will display a high marginal propensity to imports. In the case

of a fall of demand resulting form a negative shock, the higher the marginal propensity to imports

is, the smaller the effect on domestic nontradables will be, and thus, the lower the resulting

unemployment. Thus, based solely on the OCA criterion of openness, the advantages of fixed

exchange rates seem to overweigh and consequently a fixed regime would seem to be the superior

choice for an economy with a large trade sector.

Indeed, the fixed pegs among the 25 emerging market economies display a higher degree of

average openness11 than the rest (table 3 and figure 4). However, Morocco and Venezuela do not

exhibit a high degree of openness, while the significantly more open economies of the Philippines

and Thailand have floating regimes in place, indicating that there are factors other than openness

influencing the choice of exchange rate regime.

10 I will discuss the effect of indexation and currency substitution on monetary policy in more detail further below. 11 Measured as the average of exports and imports in percent of GDP.


19

Figure 4: Openness of Fixed Pegs

Openness of Fixed Pegs 2004 (in % of GDP)

0

20

40

60

80

100

120

1Malaysia Jordan China Morocco Venezuela average of other EMs

Source: World Bank, World Development Indicators

Another way openness indirectly influences the choice of exchange rate regime is through the

size of an economy. Extremely open economies are likely to be very small economies and small

economies tend to be more open than larger economies (Corden, 2002). Additionally, the benefits

of having an independent currency increase with the number of users (Levy-Yeyati et al., 2004).

Thus, one would assume for small economies to be better candidates for a regime of fixed

exchange rates. Empirical evidence confirms theoretical predictions, with only one country among

15 dollarizers and 7 currency boards having a population over 10 million (Ecuador) and the

average population being approximately 3 million.

Geographical concentration of trade: While the extent of trade is the most important factor in

determining if a country should peg its currency, the geographical concentration of trade has to be

taken into consideration as well (Larrain and Velasco, 2001). Countries that predominantly

conduct their trade with one major partner derive a greater benefit from pegging their currency (to

the partner country) than countries with a highly diversified trade base.

Asymmetric shocks: Basic economic theory states that if 2 or more countries face similar

shocks that require similar policy interventions, then the adoption of a fixed exchange rate and a

common monetary policy should not have far-reaching negative consequences for either region.

On the other hand, if 2 countries face asymmetric shocks, a common monetary policy will not be

able to suit both regions, and adjustments of the real exchange rate would be needed to

accommodate differences, which would call for flexible exchange rates. As a corollary, countries

considering pegging their currency should share a similar business cycle with their partner

country to limit the incidence of asymmetric shocks (Frankel, 2003).

Other OCA criteria: As mentioned above, even in the presence of asymmetric shocks there are

factors that can limit their magnitude under fixed exchange rates. High labour mobility, price and


20

wage flexibility, as well as fiscal transfers each provide adjustment mechanisms to cope with

asymmetric shocks in the absence of exchange rate flexibility (Frankel, 2003).

Strategic considerations: The optimal exchange rate regime for a country does not only depend

on its own characteristics, it also depends on the surrounding environment, in this case the

exchange rate arrangements of neighbors, competitors, and trade partners. By pegging to a major

currency, currency risk can be eliminated with the anchor economy, but it also means that the

economy is floating vis-à-vis all other currencies. This especially poses a problem for fixed

economies in a �neighborhood� of floaters (Larrain and Velasco, 2001). In this context the

example of Argentina is instructive. In 1999, Brazil faced a large depreciation of its currency. As

a result Argentina suffered a large loss of international competitiveness vis-à-vis its main trading

partner Brazil, which was one of the factors attributing to the severe recession and possibly to the

collapse of the currency board (Salvatore, 2002). Thus, one could assume that the number of

floating regimes in geographic and economic proximity decreases the attractiveness of fixing the

exchange rate.

The Optimal Currency Area theory can provide some helpful insights in evaluating if a country

is a good candidate to join a monetary union or to fix its exchange rate. But an evaluation based

solely on the OCA criteria would be incomplete. Moreover, the OCA theory also has its

drawbacks. First, the European Monetary Union has managed to function successfully although it

certainly does not form an optimal currency area. This has led many economists to believe the

OCA criteria are too stringent. �The point is that the requirements for having single money

developed by the optimal currency literature are so demanding as to call into question many

existing currency areas� (Fratianni and Hauskrecht, 2002, p.251-252). Second, the currency crises

in emerging market economies of the recent past have shown that international capital flows play

an increasingly important role in an increasingly integrated world. Unfortunately the OCA

approach does not take the role of financial markets and capital flows into account. Third and

most importantly, the OCA approach fails to incorporate features and characteristics that are

crucial to emerging market economies, such as, among others, credibility issues, weak

institutions, higher pass through effects and a dependency on foreign capital (Calvo and Mishkin,

2003).

For the reasons stated above, I would see the OCA approach more as a complementary tool in

the analysis and evaluation of exchange rate regime for emerging markets. In the next chapter I

will discuss the problems that are specific to emerging market economies and how they might

influence the choice of exchange rate regime.


21

5. Emerging Market Issues In many ways emerging market economies are victims of their past. Many of them, especially in

Latin America, have a history of high inflation owing primarily to the monetization of budget

deficits. Other factors such as corruption, political instability and broken promises from the

monetary authority have also certainly not encouraged price stability as well as economic stability

and development. Such events have severely damaged the image and credibility of domestic

institutions. Unfortunately, well-developed and well-run institutions are a necessary prerequisite

for the success of an exchange rate regime. Especially a credible central bank is crucial in order to

conduct a successful monetary policy. Even if a firm commitment is made towards price stability

and a �sound and correct� monetary policy is installed, this may not be enough to sufficiently

lower the public�s inflation expectations, due to a large distrust from past events.

The lack or lacking quality of political, fiscal, financial and monetary institutions paired with

the fact that large fluctuations in the exchange rate are more detrimental to the economies of

developing countries than to those of industrial countries (Salvatore, 2002, Corden, 2002), has

led many economists in the past to believe that developing countries and emerging market

economies have little to gain from a flexible exchange rate and an independent monetary

policy and, thus, would be better off adopting a foreign monetary policy and thereby fixing

their exchange rate. However, at first sight, recent trends in the popularity of exchange rate

regimes do not seem to support this view (Hakura, 2005, Frankel, 2003). Frankel (2003), for

example, observes a clear trend toward increased flexibility over the last 30 years, with the

vast majority of regimes being classified as intermediate. Unfortunately, these findings are

based on a de jure classification, with the actual/de facto behaviour of regimes not necessarily

corresponding to their classification. In reality many as managed floating or floating

announced regimes have shown a reluctance to let their exchange rate swing (freely), dubbed

as �fear of floating� by Calvo and Reinhart (2002) (table 11 and 12). But, as Calvo and

Reinhart (2002) note, it is very difficult to distinguish exchange rate regimes in general, and

regimes in the intermediate border region, say a managed float from a soft peg, in particular.

Nonetheless, empirical evidence indicates that floating exchange rate regimes in emerging

markets are more rigid than in their industrial counterparts and their de facto behaviour

indicates that they, to a certain extent, have been importing the monetary policy and

credibility of foreign countries, thereby deliberately limiting the advantages of flexibility.


22

5.1. Credibility A central issue in the debate on exchange rate regimes in emerging markets is the credibility of

domestic institutions, especially the credibility of the central bank�s commitment to price stability.

Blinder (1999, p.1) offers a simple definition of credibility: �A central bank is credible if people

believe it will do what it says.� Thus, credibility cannot be measured in statistical terms. However,

inflation performance and inflation history reveal a great deal about an economy�s credibility. Past

mistakes and failures have nagged on the credibility of monetary institutions in emerging markets

and have negatively influenced expectations and behaviour of the public. The credibility of the

monetary authority, however, does not only depend on its own actions, it also hinges on the

quality of the other institutions. For instance, large fiscal deficits, an ill-supervised banking

system and political instability all could cause large damage to an economy, so that the

commitment towards price stability has to be subordinated to a stabilization policy, possibly

causing unwanted inflation. Unfortunately, every time the central bank fails to preserve (expected)

price stability, it will become increasingly less credible. As a corollary, the public in countries

with weak central bank credibility will not take the real value of money for granted (Calvo and

Mishkin, 2003) and eventually will protect themselves by, for example, using a foreign currency

as a store of value and/or indexing their wage contracts to the rate of inflation or the exchange

rate. Moreover, high inflation and frequent depreciations of the domestic currency increasingly

undermine the effects of monetary policy on the real economy, while concomitantly increasing the

effects on inflation and nominal interest rates.

Thus, for economies starting from a situation, where the public questions the credibility of the

monetary authority, fixed exchange rate regimes hold an advantage over flexible regimes. By

implementing a hard peg, an economy instantaneously imports the credibility and monetary

stability of the country it pegged its currency to, helping to quickly reduce inflation. On the other

hand, flexible exchange rates will have to �build� that credibility by themselves, which is needless

to say by far the more difficult process (Larrain and Velasco, 2001). In contrast to hard pegs, the

possibility of inflationary finance can never be totally ruled out. Hence, for emerging market

countries with recurring inflation problems an absolutely fixed regime can provide more

credibility than a floating regime (Corden, 2002).

However, some economists question the desirability of fixed exchange rate regimes and see them

as second best solutions, or rather as the consequence of economies with weak institutions that are

not able to solve their credibility problems on their own (Levy-Yeyati et al., 2004). �In the case

of unilateral dollarization or euroization, stability is imported because previously unstable

countries are not able to implement necessary monetary and fiscal reforms that lead to stable


23

economic development on a credible and permanent basis�(Volbert and Loef, 2002, p306).

Empirical results by Levy-Yeyati et al. (2004) suggest that the propensity to peg is higher for

developing economies with low institutional quality, relying on the exchange rate anchor to

compensate for low credibility.

While the advocates of fixed exchange rates stress the inflation reducing capabilities of fixed

exchange rate regimes due to the enhanced credibility and discipline, the adoption of such a

regime for countries with high inflation is nonetheless somewhat of a paradox (IMF, 1997).

Essentially high rates of inflation and a fixed exchange rate are not sustainable. Developing

countries with a fixed exchange rate and a higher rate of inflation than the country they

pegged to will experience a real appreciation of their exchange rate, which reduces their

international competitiveness and also leads to a worsening of the current account (IMF,

1997). As a result, the peg will become misaligned, putting pressure on the exchange rate and

the financial sector, eventually making an adjustment of the exchange rate inevitable. The

relative short duration of most exchange rate pegs12 indicates that fixing the exchange rate

entails problems of its own, such as a loss of competitiveness, and is not an everlasting

solution for economies with credibility problems.

Credibility problems per se can arise both under flexible and fixed exchange rate regimes. But

they differ due to the different objectives of monetary policy.

Under flexible exchange rates, the commitment to price stability determines the credibility of

monetary policy. Thus, the monetary authority will have to convince the public that they are only

committed to the pursuit of their policy targets and that excessive inflation will not occur again.

Under flexible exchange rates the best way to achieve this is by using an inflation targeting

policy. Credibility enhancing measures include providing the public with detailed information on

inflation results, targets and forecasts, current and future policies as well as possible obstacles

(Mishkin, 1999). But ultimately, the credibility of flexible exchange rate regimes will increase the

longer they are successfully able to preserve price stability (Corden, 2002, Mishkin, 1999).

In contrast to flexible regimes, under fixed exchange rates price stability is not a direct issue. By

fixing the exchange rate, an independent monetary policy is given up and the commitment to price

stability is imported with the monetary policy of the anchor currency country. Thus, the exchange

rate serves as the nominal anchor for monetary policy and the credibility depends on the

commitment to the exchange rate peg, or put in other words, on the public�s perception of the

chances that the fixed exchange rate will be abandoned. A high level of foreign reserves increases

a country�s ability to defend a fixed exchange rate and thereby enhances the credibility of the peg. 12 See, for example, IMF (1997)


24

But ultimately, the larger the economic and political costs associated with a collapse of the peg,

the higher will the incentive be for the government to defend the regime, which in turn will

increase its credibility (Schuler, 2000). Credibility can also be seen as an indicator of the rigidness

of a fixed regime and vice versa, with hard pegs profiting from the benefits of high credibility and

soft pegs, with their escape clauses, profiting less from credibility but instead deriving benefits

from their enhanced flexibility (Schuler, 2000, Larrain and Velasco, 2001).

The choice of exchange rate regime hinges to a great part on the credibility of a country�s

monetary and the quality of its other institutions. Weak institutions and a central bank that lacks

credibility towards price stability do not favour the adoption of flexible exchange rate regimes.

However, a qualification must be noted, countries with large fiscal imbalances in the long-run

have no other choice than to opt for a regime with floating exchange rates (Corden, 2002).

5.2. Access to International Financial Markets

A problem that is linked to the lacking credibility of monetary and fiscal policies in

emerging markets is their access to international financing compared with developed

economies (Calvo and Reinhart, 2000). In the past, emerging market countries have been highly

dependent on foreign international capital to finance their growth due to the relatively shallow

domestic financial markets (Calvo, 1999). Lower credibility translates into lower credit ratings,

which in turn means emerging markets will have to offer higher interest rates in order to

attract funds. Using the credit ratings of two internationally renowned agencies, Moody�s and

Institutional Investor, for a sample of 25 countries during a 30 year time period, Calvo and

Reinhart (2000) observe that the level of credit ratings for emerging markets is on average a

third to half of that assigned to developed economies. Furthermore, the authors show that

following a large devaluation of the domestic currency emerging markets experience a far

greater credit rating downgrade than developed economies.13 However, the devaluations and

associated credit downgrading are not always the result of weak domestic polices. They can

be caused by factors external to a domestic economy, most notably contagion, as the

experiences from past crises have shown (IMF, 2003). As a consequence of the lower credit

rating international investors will demand a higher yield (Calvo and Reinhart, 2000) and

emerging markets will face higher debt-servicing costs associated with a higher chance of

13 �In the twelve months following the currency crisis, the magnitude of the downgrade is about five times greater for emerging markets than it is for developed economies. The differences between the post-crisis downgrade for emerging and developed economies is significant at standard confidence levels. � Calvo and Reinhart (2000, p13)


25

default and additionally putting considerable stress on the already rather weak financial

system. Alternatively, if interest rates are not raised sufficiently, the emerging market will not

be able to attract foreign capital and the economic contraction will be more pronounced.

Thus, devaluations in emerging markets lead to a limited access to international funds or to

borrowing costs that might jeopardize the health of the financial system, both of which help

deliver a possible explanation as to why emerging markets are reluctant to face large

exchange rate swings.

5.3. Sudden Stops and Currency Crises While the incidence of sudden stops is neither a new nor a rare phenomenon, and certainly

not one that is limited to emerging market countries, sudden stop issues have really come to

the fore in context with the financial and currency crises to emerging market economies of the

past decade. The affected countries faced large devaluations of their currencies and the

volatility of capital flows became a serious problem as capital inflows ceased and in some

countries even reversed. While there are several different definitions of a sudden stop, a

sudden stop initially refers to a large decline in capital inflows to a country. However,

economic literature tends to focus on the cases where a sudden stop in capital inflows is

accompanied by a contraction in output. The reasons for this decline in capital inflows can

vary and be of domestic origin, such as political instability, banking and currency crises, or of

external origin, such as changes in international interest rates or contagion (Guidotti et al.,

2004). However, the latter seems to be of greater importance as the incidences of emerging

market sudden stops in the past decade were not uniformly distributed, but rather were

bunched around periods of emerging market crises (Calvo et al., 2004). Furthermore,

countries that were simultaneously affected by sudden stops were quite heterogeneous in their

macroeconomic fundamentals as well as in their geographic location.

To take a closer look at the effects of sudden stops, it is helpful to take a look at the national

economic accounts:

Y- E ≡ CA (NX) - CA + ∆R ≡ KA Where Y denotes income, E is absorption/aggregate demand, CA the current account, KA

the capital account, and ∆R the change in international reserves.


26

By definition, net capital inflows must match the current account deficit and the change in

international reserves. Hence, a reduction in capital inflows, will result either in an

amelioration of the current account and/or a loss of reserves. A reduction of reserves reduces

a country�s capability to control its exchange rate, thereby increasing the likelihood of

speculation and a currency crisis, while an amelioration of the current account in the wake of

a sudden stop is mostly compensated by a fall in aggregate demand and, thus, has negative

consequences on employment and output (Calvo and Reinhart, 2000). Indeed, findings of

Calvo et al. (2004) support traditional economic theory, as they observe that sudden stops are

associated with reserve losses and large current account adjustment as well as large upswings

in interest rates.

A key distinction between developing and developed countries is that empirical evidence

indicates that large real depreciations in emerging markets are usually associated with sudden

stops, whereas in developed economies this phenomenon is rather rare (Calvo et al., 2004).

This suggests �large real exchange rate fluctuations accompanied by sudden stops are

basically an emerging market phenomenon� (Calvo et al., 2004).

Calvo and Reinhart (2000) investigate the effect of currency crises on the incidence and

magnitude of sudden stops, as well as the effect on output. They take a closer look at 96

currency crises, of which 25 occurred in developed economies and the remaining 71 in

developing countries. Regarding a two year time period for every currency crisis, with the

first year preceding the crisis and the last succeeding it, the authors conclude that a currency

crisis leads to an improvement of the current account and a reduction of growth in both types

of economies. But, the authors also find that the magnitude of sudden stops, measured as

current account adjustment during the time period, and growth reduction differ significantly

between developed and developing economies, both economically and statistically. The

difference in current account adjustment is five times larger (3.5% compared to 0.7%) for

developing economies14, while the growth reduction is 2% compared to 0.2% for developed

economies during the two year time period. The authors see the main reason for the larger

economic damage of currency crises and the occurrence of sudden stops in emerging markets

in their inability to generate sufficient funds, which is caused by the acute deterioration of

borrowing conditions and associated loss of access to international finance due to lower credit

ratings, and the relative shallow domestic financial markets.

14 Guidotti et al. (2004) and Calvo et al. (2004) also find developing countries are associated with much larger adjustments in the current account than developed economies.


27

Looking for factors that influence the occurrence of sudden stops Frankel and Cavallo

(2004) find that openness significantly reduces the probability and the associated costs of a

sudden stop (and currency crisis), whereas a large initial current account deficit increases the

probability. Calvo et al. (2004) find that trade openness (negatively) and domestic liability

dollarization (positively) are the key determinants of the probability of sudden stops. While

Guidotti et al. (2004) find that low levels of liability dollarization, floating exchange rates and

a high level of openness are conducive to a rapid recovery from a sudden stop.

Other factors influencing the incidence of sudden stops, such as political instability and

contagion, occur regardless of the exchange rate regime in place. However, as mentioned

above, currency crises often appear together with sudden stops and the former do seem to be

linked to the choice of exchange rate regime (Mussa et al., 2000). Rogoff et al. (2003) using a

de facto classification of exchange rate regimes find that twin (banking and currency) crises in

emerging markets occurred more often in pegged regimes and that their incidence decreased

with increasing flexibility of regimes.

5.4. Trade Issues

The standard trade invoicing rule among industrialized countries that goods tend to be

denominated in the currency of the exporting country (McKinnon, 1999) does not apply very well

to emerging market economies. Instead, international trade involving an emerging market

economy is usually invoiced in the currency of the larger economy. Moreover, very often

trade among emerging market economies is invoiced in dollars or euros (Clark et al. 2004,

30). Goldberg and Tille (2004) show that while the share of exports invoiced in the currency

of the exporter is above 90% for the United States, and above 50% for the UK, Germany and

France, the emerging market economies of Korea and Thailand exhibit a share below 10%.

Studies analyzing the effect of exchange rate variability on trade in emerging markets15 seem

to lean towards the hypothesis that exchange rate variability has a negative effect on trade,

which is arguably larger than in industrialized economies (Calvo and Reinhart, 2000). Clark

et al. (2004) find that volatile exchange rates are more likely to be associated with smaller

trade for developing countries than for advanced economies. However, their results are not

very robust; the introduction of time varying effects in the regression erodes the impact of

volatility on trade flows. Arize et al. (2000, 2005) come to the conclusion that there is a

15 For an overview of the literature, see Calvo and Reinhart (2000), p.16.


28

negative and statistically significant relationship between export flows and exchange-rate

volatility in both the long- and short-run in each of the thirteen less developed countries and

eight Latin American countries in their respective studies. Broda and Romalis (2003) find that

the depressing effect of volatility on exports is greater for emerging markets than for

developed economies.

While the reasons for the alleged vulnerability of emerging markets to swings in the

exchange rate are manifold and could range from the trade invoicing patterns over limited

hedging possibilities to a higher risk adversity of exporters, empirical evidence suggests that

reducing exchange rate variability could enhance trade, especially for emerging markets.

5.5 Effectiveness of Monetary Policy In the past, most emerging market economies and developing countries have not been able to

derive a great profit from using discretionary monetary policy, or have used monetary

independence for other purposes than in industrial countries. Hausmann et al. (1999) come to the

conclusion that flexible exchange regimes neither deliver much insulation from shocks nor

provide much room for monetary policy autonomy, while lacking the credibility of hard pegs.

A history of high inflation and/or lacking central bank credibility have taken the �surprise� out

of surprise inflation, so that countercyclical monetary policy does not have the desired effect on

output and unemployment in many emerging market countries (Larrain and Velasco, 2001).

Furthermore, the dependency of emerging markets on foreign capital and the higher volatility of

international capital flows complicate the conduct of a monetary policy. In times of economic

downturn, interest rates, and hence monetary policy, often do not take domestic considerations

into account and behave in a procyclical manner to preclude an outflow of foreign capital and help

stabilize the exchange rate (Calvo and Reinhart, 2002). An additional difficulty has been that tax-

collecting systems in many developing countries have proven to be inefficient and weak, with tax

evasion being widespread. With the fiscal base being very small, a discretionary monetary policy

often has been misused in the past as an additional source of revenue through the inflation tax

(Calvo and Reinhart, 2002).

5.5.1. Monetary Independence

Following conventional economic theory, one would expect monetary independence to be

greater under floating exchange rates, as interest rates can be set independently and are not


29

determined by foreign policies as in the case of fixed exchange rates (Frankel et al., 2002).

However, empirical evidence is far less clear-cut than economic theory.

Shambaugh (2004) finds evidence for the notion of the impossible trinity. In a sample of over

100 developing countries divided into de facto pegs and non-pegs from 1973 through 2000, the

author finds that the exchange rate regime along with capital controls seem to explain the extent to

which a country follows foreign interest rates. For developing countries pegging significantly

increases sensitivity to foreign interest rates, while capital controls (for fixed regimes) do the

opposite. Further important findings are that in pegged regimes interest rates are lower and more

stable, while in non-pegged regimes foreign interest rates are not a good indicator of domestic

monetary policies, implying that these countries have a reasonable amount of monetary autonomy.

Frankel et al. (2002) analysing a sample of 18 industrial and 28 developing countries over a time

period from 1970-1999 find that results for the entire sample confirm conventional wisdom, with

floating regimes displaying less sensitivity to foreign interest rates and fixed regimes displaying

lower interest rates. However, in the 1990s both industrial and developing countries displayed full

or near-full adjustment of local interest rates to foreign interest rates, with fixed regimes

displaying a significant over-adjustment. While developing countries, regardless of their regime,

adjusted to interest rates set in the financial centres, countries with flexible rates did appear to

have a higher degree of monetary independence, albeit temporary, as hard pegs displayed a

quicker adjustment than other regimes.

In an attempt to measure monetary independence Borensztein et al. (2001) compare the currency

boards of Hong Kong and Argentina with the floating regimes of Singapore and Mexico during

the 1990s. This country comparison entails the advantage that the country pairs share broad

similarities and that classification problems can be circumvented, as the floaters do not exhibit

much fear of floating. Additionally for benchmark purposes the authors include the industrialized

floating economies of Canada, Australia, and New Zealand as well as Chile. Using VAR models

the results obtained are broadly consistent with the view that floating regimes deliver more

monetary independence. While all 4 economies displayed a significant impact of changes in US

interest rates on domestic interest rates, the effect was significantly larger for the currency boards.

Additionally, shocks to emerging market risk premia had smaller effects in Singapore than in

Hong Kong, however, contrary to the conventional view, interest rate reactions to such shocks

were nearly identical in size for the economies of Mexico and Argentina. Hausmann et al. (1999)

find that the reaction of domestic interest rates in 11 Latin American countries is similar across

different regimes for a time span from 1960-1998. Moreover, for a short 2-year time span from

1998-1999, the authors find that changes in international risk premia had the largest effects on


30

interest rates in the floating regime of Mexico16. However, unlike Borensztein et al. (2001) the

authors did not control for exchange rate movements, thereby biasing the interest rate effect

upwards.

A possible explanation for the lacking insulation flexible regimes provide regarding increases in

interest rate premia is a lack of credibility, typically associated with flexible regimes, which

offsets the increased flexibility and independence advantages flexible regimes initially possess

(Calvo and Reinhart, 2002). In countries where expectations about future inflation and exchange

rate development are volatile and uncertain, interest rates are likely to be high and volatile. Risk

premium shocks will unleash fears of devaluation and default, which typically will be greater

under a flexible regime (that lacks credibility) than under a fixed regime, forcing a greater

adjustment of domestic interest rates and thereby possibly explaining the higher variance of

interest rates to risk premium shocks in some floating emerging markets. Indeed, reviewing the 3

emerging market floaters Singapore, Chile and Mexico documented in Borensztein et al. (2001),

the 2 economies that displayed increased monetary independence, Singapore and Chile, had low

levels of inflation, while Mexico did not.

Figure 5: Inflation in Mexico, Chile and Singapore

However, focusing solely on

domestic interest rate

movements can underestimate

the actual degree of monetary

independence, as high interest

rate sensitivity could be caused

by similar business cycles

and/or similar shocks. Capital controls also play a decisive role as they increase monetary

autonomy under fixed exchange rates. Fear of floating also limits monetary autonomy as

economies deliberately decide to limit exchange rate variability by using the interest rate as an

instrument for this purpose (Frankel et al., 2002). However, floating regimes under inflation

targeting use interest rates as a policy instrument, and therefore it is very difficult to quantify

their actual amount of monetary independence (Calvo and Reinhart, 2002).

Although the empirical evidence is mixed and measuring the amount of monetary

independence an individual country possesses is a difficult and complicated procedure, a

16 Hausmann et al. (1999, 12) find that a 1% increase in foreign interest rates leads to a 1.45% increase in Argentina and a 5.93% increase in Mexico.

0%

10%

20%

30%

40%

92 93 94 95 96 97 98 99 00Chile Mexico Singapore

source: IMF WEO database


31

number of studies seem to support the �conventional� view that floating reduces the need to

adjust domestic interest rates in response to external shocks. Likewise empirical evidence

suggests that this increased autonomy comes at the cost of higher average interest rates.

However, floating exchange rates do not necessarily provide emerging markets with increased

monetary independence, as lacking credibility of domestic policies can more than offset the

advantages of increased flexibility.

5.5.2. Is Expansive Monetary Policy Contractionary? Advocates of fixed exchange rate regimes argue that in the past devaluations or large

depreciations of the domestic currency in emerging markets were not expansionary, as

suggested by standard textbook models, but in fact tended to be contractionary (Calvo and

Reinhart, 2000).

Conventional wisdom predicts that in the short run nominal devaluations are thought to be

contractionary, while in the long run they are expansionary (Corden, 2002). While in the short

run the absorption reducing effect dominates, in the long run the stimulating effect of

improved competitiveness on exports kicks in. However, the effect of devaluation also

depends on the structure of an economy. Corden (2002) sees unhedged foreign currency

liabilities and reductions or even reversals of capital flows as the principal reasons for the

predominantly contractionary effects of devaluations in emerging markets, as they increase

the negative effect on domestic absorption. Similarly, Calvo and Reinhart (2000) see

emerging markets� loss of access to capital markets and their pervasive liability dollarization

mainly responsible for devaluations having a contractionary character.

Empirical evidence indicates that indeed the majority of devaluations were in fact

contractionary17. Gupta, Mishra, and Sahay (2003) using a sample of 195 crises episodes in

91 developing countries during 1970-98 find that 43 percent were expansionary, that the

corresponding share of crises was 30 percent for large emerging markets, and that this ratio as

well as the magnitude of contractions has remained relatively unchanged throughout the 3

decade time period. The authors find the volume of capital flows, the cyclical situation, the

level of per capita income, and the ratio of short-term debt to reserves negatively influence the

output response. On the other hand a larger tradable sector and export growth, which in turn is

negatively influenced by simultaneous devaluations of other countries, are found to increase

the expansionary effect. 17 For an overview of empirical literature and results on this topic, see Gupta et al. (2003).


32

A qualification from advocates of flexible exchange rates to the approach chosen by Gupta

et al. (2003) might be that it is too short-term, as it considers the output response merely two

years after the crisis, thereby possibly not considering the full expansionary effect.

Furthermore, empirical literature predominantly focuses on crisis episodes. However,

devaluations in floating regimes need not result in a (contractionary) currency crisis, and

severe currency crises in the past often have been the result of unsustainable pegs (Larrain and

Velasco, 2001). As mentioned further above, Rogoff et al. (2003) finds that in the past for

emerging markets the likelihood of facing a currency crisis was higher under pegged regimes

and decreased with the flexibility of the regime.

While not all devaluations in emerging markets are contractionary, and examples of the

past, such as Brazil and Mexico18, show that devaluations can be expansionary even among

large emerging market floaters, results show that there are undoubtedly impediments in many

emerging markets to the conduct of an independent monetary policy and, hence, to the

adoption of floating exchange rates.

5.5.3. Pass Through Issues

One of the factors complicating the conduct of monetary policy is a high pass through from

exchange rates to inflation, which is primarily a consequence of a history of inflation in many

emerging markets and the associated lacking credibility to price stability (Mishkin, 2004). If

depreciations of the domestic currency occur frequently, the public will correspondingly adapt

its expectations. A higher pass through from the exchange rate to inflation increases the bulk

of adjustment borne by the price level, thereby reducing the ability of the nominal exchange

rate to influence the real economy and ultimately limiting the effectiveness of the exchange

rate as a policy instrument. Moreover, monetary policy must be diverted to a greater extent to

limit exchange rate swings in order to contain inflation. Thus, a high pass through from

exchange rates to inflation would initially speak for fixed exchange rates.

Calvo and Reinhart (2000) provide empirical evidence that the incidence and magnitude of

pass through effects are higher in emerging market economies. The authors study a sample of

39 countries using a bivariate autoregressive VAR model. Their most important findings are

that, first, exchange rate changes in emerging markets have a higher incidence of having a

statistically significant effect on inflation in emerging markets (43 percent) than in developed 18 �The Brazilian and Mexican cases support the notion that devaluations may be expansionary in the medium run without inflationary consequences, provided credible monetary and fiscal policies are adopted� (Goldfajn and Olivares (2001, p.10).


33

countries (13 percent) and, second, that the average pass through is about four times as large

for emerging markets than it is for developed economies. Estimates of inflation pass through

from Hausmann et al. (2000), though not as clear, point in the same direction. Goldfajn and

Werlang (2000) also come to the conclusion that the pass-through is markedly lower in

OECD countries relative to emerging market economies. Additionally, they find that the main

determinants of pass through, are real exchange rate overvaluation, the initial rate of inflation,

trade openness and the output gap, with the first mentioned being the most important factor

for emerging markets.

The pass through effect from exchange rates to inflation may help to explain a fear of

floating displayed by some emerging market countries, as higher inflation would conflict with

the attempt to establish monetary credibility. However, recent studies19 indicate that the pass

through effect is decreasing for several emerging market economies, reducing the importance

of the issue (Reyes, 2004, IMF, 2001). Interestingly, the decline in pass through coincided

with the adoption of inflation targeting in several countries20, what Reyes (2004) uses to

document a relationship between the lower pass through and the adoption of inflation

targeting. However, high pass through effects seem to be the consequence of high inflation

and the associated lacking credibility of monetary institutions towards price stability. Thus,

sustained periods of low inflation, regardless of the regime, will help alter the public�s

expectations and thereby contribute to a lowering of the pass through from exchange rates to

higher prices (Mishkin, 2004). Indeed, the improved inflation performance of emerging

markets has coincided with a decline of pass through effects, which undoubtedly strengthens

the case for enhanced exchange rate flexibility.

5.5.5. Wage Indexation In countries with a history of high inflation and/or �incredible� monetary institutions the public

has adapted to the unpredictable environment by indexing their wages. Wage indexation to

inflation or the exchange rate guarantee that the public will not lose purchasing power parity due

to changes in the price level or a depreciated exchange rate.

The prevalence of wage indexation has a significant influence on the choice of exchange rate

regime. In �normal� economies under floating exchange rates a depreciation of the exchange rate,

caused by monetary expansion, is expected to increase competitiveness and have real effects. The

crucial assumption is that the nominal wage is rigid (in the short-term) while the real wage is

flexible. The presence of wage indexation reverses the situation: real wages are rigid, while 19 For an overview of the literature see Reyes (2004), p.2. 20Examples are Brazil, Mexico and Chile.


34

nominal wages are flexible. The result is that nominal devaluations will not lead to real

devaluations. Depreciations of the nominal exchange rate will be compensated by increases of the

price level. Thus, a monetary expansion will not have an effect on employment and will just cause

the nominal exchange rate to drop and inflation to rise. In the case of perfect wage indexation

monetary interventions would be useless (Corden, 2002). Thus, wage indexation deprives flexible

regimes of their biggest advantage, namely to react to negative shocks and conduct a

countercyclical policy.

In reality, wage indexation is almost never perfect. Wages indexation is usually a backward-

looking process, indicating that nominal adjustments will take place with a time lag (Larrain and

Velasco, 2001). Therefore a depreciation will have real effects, although only temporary until the

wages adjust to their new price level. A lasting effect could be achieved by continuous

depreciation of the exchange rate, but this would come at the cost of high inflation. (Corden,

2002)

Does the choice of exchange rate regime have an impact on the occurrence of wage indexation?

Hausmann argues (1999, p15) that past and present inflation is not the only reason for the

appearance of wage indexation. The authors argue that flexible exchange rate regime increase the

likelihood of wage indexation, owing to the fact that possible devaluations are expected by the

domestic work force and the presence of wage indexation will reflect these expectations.

But the recent experiences of Chile (Lefort and Schmidt-Hebbel, 2002), which was able to

reduce its indexation under a floating exchange rate regime, and Brazil (Goldfajn and

Olivares, 2001), which implemented a floating inflation targeting regime in 1999 and endured

a devaluation without subsequent wage compensation after a prolonged period of price

stability, indicate that solely the price stability of a regime, and not the type of regime, is

responsible for the occurrence of wage indexation.

5.5.6. Unofficial Dollarization Unofficial dollarization is basically also a form of indexation and it is a widespread phenomenon

in many emerging markets21. �Unofficial or de facto dollarization results from individuals and

firms voluntarily choosing to use foreign currency as either a transaction substitute (currency

substitution) or a store of value substitute (asset substitution) for the monetary services of

domestic currency� (Feige and Dean 2002, p.320). The replacement of the domestic currency with

a foreign one as a store of value is a sign that the public does not expect the purchasing power

parity of their currency to remain stable, either through inflation or devaluation. However, the

21 Dollarization refers to foreign currency in general, and not specifically to the dollar.


35

substitution of domestic currency also occurs due to the dominance of foreign of currencies in

international transactions (Calvo and Mishkin, 2003). Confirming this notion, the major reason for

the observed currency substitution in Central and East European economies has been the prospect

of joining the European Monetary Union (Feige and Dean, 2002).

Conventional economic theory predicts that in an economy with unofficial dollarization, the

domestic money supply does not equal the effective money supply. The conduct of an

independent monetary policy under flexible exchange faces difficulties in the presence of

widespread currency substitution. First, the amount of foreign currency in circulation is difficult

to estimate and the demand for domestic money is less stable, thereby complicating policy

decisions and making the outcome of policy measures difficult to predict. Second, under extensive

currency substitution the effectiveness of policy decisions is likely to be lower, as a monetary

expansion could cause a crowding-out effect from the domestic currency to the foreign currency,

thereby negating the expansionary effect (Feige et al., 2002).

While unofficial dollarization is in part a consequence of inflationary monetary policies and

weak monetary institutions, Hausmann et al. (1999) observe that Latin American countries

enjoying recent price stability have not seen a decline of their unofficial dollarization ratio. Feige

et al. (2002) suggest that once unofficial dollarization reaches a certain threshold, it becomes

persistent and nearly irreversible owing to the fact that network externalities lower the transaction

costs of the foreign currency to the point where they are lower than switching back to the

domestic currency. Using a network externality model, they estimate the threshold to be 35% of

the effective money supply for Argentina. Several Latin America countries including Argentina

exceed the 35% threshold, implying that they could be permanently dollarized.22Consequently,

from this point of view it would make more sense for such economies to adopt a fixed exchange

rate or to even go a step further and dollarize.

A contrasting point of view suggests that unofficial or partial dollarization is not irreversible and

can be influenced by deliberate policy decisions. De Nicolo et al. (2003) find that administrative

restrictions as well as improved credibility and institutional quality, albeit to a lesser extent, play a

potential role in the dedollarization process of economies. However, like Hausmann et al. (1999),

Reinhart et al. (2003) note that a period of stable inflation might not suffice, or will take a very

long time period, to reduce dollarization. Regarding a sample of 90 developing countries from

1980 to 2001 the authors find that while countries with high inflation display a higher degree of

dollarization, countries experiencing successful disinflations have not been able to lower their

dollarization levels, as only 2 countries were able to reverse dollarization without significant

costs. Furthermore, the authors contradict conventional wisdom and suggest that partial

22 Estimates of unofficial dollarization for Latin America countries as well as Central and Eastern European countries can be found in Feige et al. (2002) and in Feige and Dean (2002).


36

dollarization has no significant influence on the effectiveness of monetary policy, as highly

dollarized economies were able to lower inflation and displayed output volatilities similar to those

of less dollarized economies. However, output volatility was markedly higher for countries with a

high degree of dollarization from 1996 through 2001. The most evident difference found in the

study was that higher dollarized economies displayed a higher pass through effect and were

associated with a significantly lower amount of exchange rate variability.

According to other economists this fear of floating, or low variability of real exchange rates, is

one of the reasons why developing countries have not been able to lower dollarization despite

relatively low and stable inflation (De Nicolo et al., 2003, Fernández-Arias, 2005). This notion

suggests that foreign currency holdings depend on the relative risk between inflation and real

exchange rates. Consequently, the larger decrease of variability for real exchange rates than for

inflation in many economies explains the persistence of dollarization despite low inflation. Hence,

from this point of view there is a role for monetary and exchange rate policy in the reduction of

dollarization.

While the empirical evidence on the effectiveness of monetary policy in partially dollarized

economies is not clear cut, it does clearly indicate that highly dollarized economies limit swings in

their exchange rate, thereby limiting the potential benefits of floating exchange rate regimes and

subsequently strengthening the case for fixing. However, partial dollarization comes at a cost, as

it can create currency mismatches, which increase the fragility of the financial system. While

containing or even reducing dollarization has gained importance in policy objectives in

developing countries, the success has been very limited (Reinhart et al., 2003). Nonetheless,

flexible exchange rates seem to be a key ingredient in the path to success (De Nicolo et al., 2003,

Fernández-Arias, 2005).

5.5.7. Currency Mismatch As mentioned above, large currency mismatches pose a serious threat to the financial stability of

emerging markets as they increase the likelihood of facing a financial crisis as well as the costs of

getting out of one (Goldstein, 2004). Devaluations of the domestic currency, which are often

accompanied by sudden stops, deteriorate the balance sheets of borrowers subject to currency

mismatches and thereby severely complicate the conduct of exchange rate and monetary policy.

Many economists23 see currency mismatches as the main reason for the finding that emerging

markets have displayed a fear of floating and that devaluations in emerging markets have tended

to be contractionary.

23 See, for example, Corden (2002).


37

Goldstein defines a currency mismatch as: �A situation in which the currency denomination of a

country�s or sector�s assets differs from that of its liabilities such that its net worth is sensitive to

changes in the exchange rate� (Goldstein 2002, p.44). In the case of emerging markets the

currency mismatch problem arises because a great deal of their liabilities are dollarized while their

assets are not, or not as much. Many economists tend to focus on the liability side of currency

mismatches (liability dollarization). However, liability dollarization per se is not a problem, if a

country has sufficient foreign assets to match its foreign liabilities. Thus, to control for currency

mismatch one should view both sides of the balance sheet. Regarding liability dollarization, it is

evident that high levels of foreign debt pose a bigger threat to closed economies (Calvo and

Mishkin, 2003).

In regimes that lack credibility, regardless if fixed or floating, the public will have the possibility

of a devaluation incorporated in their expectations and, hence, will prefer to hold domestic assets

in a more stable currency. �Because of uncertainty about the future value of the domestic

currency, many nonfinancial firms, banks and governments in emerging markets find it much

easier to issue debt if the debt is denominated in foreign currencies�(Mishkin 1999, p.7).

Consequently, bank deposits and saving accounts in foreign currency as well as domestic bonds

denominated in foreign currency will seem increasingly more attractive the lower domestic

credibility is. In an attempt to avoid exchange rate exposure to their balance sheets banks will be

compelled to offer foreign currency loans, thereby transferring the currency risk to their mostly

unhedged clients (de Nicolo et al., 2003). Additionally, foreign currency loans may be favored by

local borrowers, as they could seem to be the initially cheaper financing method due to the

elimination of currency risk (IMF, 2003a). Other large sources of currency mismatches in

emerging markets arise from cross border bank lending and international bonds, both of which are

practically exclusively denominated in foreign currency (Eichengreen et al., 2002).

The economies of emerging markets today typically have a large share of their liabilities as well

as their assets denominated in foreign currency, making them sensitive to changes in the exchange

rate. In the presence of widespread currency mismatches among borrowers a devaluation of the

domestic currency will lead to an increase of their debt burdens and a deterioration of their

balance sheets. As a result, a higher number of borrowers will default on their loans than under

normal circumstances. Although financial intermediaries can manage and possibly eliminate their

own currency and maturity mismatches, as long as their customers are exposed to an exchange

rate risk, so are they. In turn, the increase of nonperforming loans leads to deterioration of banks�

balance sheets, which could cause large-scale bankruptcies and/or a marked reduction of lending.

Financial intermediation will no longer be able to efficiently allocate resources, spending will also

decline as a result of the unavailability of loans and the reduction of net worth and consequently

the economy will have to endure an economic contraction. Once devaluation has occurred there is


38

not much the domestic monetary authority in an emerging market can do (Mishkin, 1999).

Whatever policy actions the monetary authority chooses, it will not be able to avoid a further

deterioration of domestic balance sheets and associated bankruptcies. If the monetary authority

raises interest rates to support the exchange rate, it will reduce aggregate demand and more

importantly it will result in an increase of debt burdens of borrowers, possibly leading to a

collapse of the banking system. On the other hand, expansionary monetary policy will not lead to

a stimulation of aggregate demand or a reduction of debt burdens either. Lowering the interest rate

will entail a massive outflow of capital as well as a further depreciation of the domestic currency,

thereby increasing the negative balance sheet effect. Thus in the presence of large currency

mismatches an expansionary monetary policy is very likely to have contractionary effects, as was

the case notably during the Asian crisis (Mishkin, 1999).

The ability of emerging market economies to deal with currency mismatches depends on a

number of factors. Due to their low credit ratings, emerging markets access to international

markets is limited, especially in times of stress (Calvo and Reinhart, 2000). In this case a high

level of foreign reserves not only serves to reduce the aggregate currency mismatch in an

economy, but they can substitute for lacking access to international financial markets in order to

support the exchange rate (Goldstein, 2004). Likewise domestic financial markets could also

provide the needed capital and take some pressure off the banking sector.

The easiest way to circumvent the problem of currency mismatching would be to dollarize.

However, shallow financial markets partly resulting from high inflation, poor regulation and

lacking incentives are the principal reason for the occurrence of currency mismatch problems. In

this sense, such problems could be avoided or reduced with stronger institutions and the

implementation of the right policies under non-dollarized regimes (Goldstein, 2004).

Monetary policy without a credible commitment to low inflation will discourage the use of the

domestic currency in financial transactions, and consequently impair the development of domestic

financial markets, especially the development of long-term debt and foreign exchange

instruments, which are crucial to reduce the reliance on foreign currency debt (Jeanne, 2003). In

this context it is important to distinguish between domestic and international debt. While domestic

debt tends to be denominated in local currency and domestic policies and institutions influence its

currency composition, international debt is denominated almost exclusively in foreign currency

and its currency composition seems to be determined by factors that lie beyond the control of

domestic policymakers, such as the importance of hard currencies in international transactions,

which entail lower transaction costs, as well as the general structure and practices of international

financial markets (Eichengreen et al., 2002). In a series of papers Eichengreen, Hausmann, and

Panizza document the inability of emerging market economies to use their domestic currency to

borrow internationally or to borrow long term, even domestically, and label this phenomenon as


39

�the original sin�24 (Eichengreen and Hausmann, 1999). The authors find that countries with

original sin are likely to be characterized either by currency or maturity mismatches, which

ultimately translate into higher output and capital flow volatility, lower credit ratings, and greater

stability in the exchange rate (Eichengreen et al., 2002). However, while their finding that

deliberate policy measures have little influence on the foreign currency component of

international bonds seems persuasive (Eichengreen et al., 2002), original sin as an accurate

measure of currency mismatches has several drawbacks.25 The development of deeper local bond

markets is crucial to the currency mismatch problem in emerging markets, as it allows emerging

markets to offer increased local finance at lower costs and thereby increase the share of local

currency in domestic funding and concomitantly decreases the need for funding in international

markets (Jeanne, 2003). Additionally, deeper bond markets would increase the availability of

hedging instruments and hence the ability to cope with exchange rate risk, and reduce the pressure

on banks as the primary source of funding (IMF, 2003a). Furthermore, deeper bond markets

would possibly permit the separation of currency and credit risk, allowing a more efficient

allocation of currency risk to those who can match it best (Goldstein, 2004). Indeed, the main

distinction between domestic bond markets of emerging markets and industrialized countries is

not their currency composition, which is similar except for Latin America, but rather the much

larger size of bond markets in developed countries (Goldstein, 2004). Empirical researches

indicate that countries that have higher inflation tend to issue more foreign currency denominated

debt (Goldstein, 2004).

A number of economists see another reason for large currency mismatches in the wrong feeling

of security fixed (but adjustable) exchange rate regimes provide, which lead to large unhedged

foreign positions (Corden, 2002). �Pegging the exchange rate may have a hidden cost because it

may encourage excessive risk taking and volatile capital inflows� (Mishkin, 1999, p.13-14). The

countries affected by currency crises in the last decade all displayed little variability in their

exchange rates. Unlike fixed or overly managed exchange rates, flexible rates remind market

participants of the currency risk involved in transactions and thereby give an incentive to hedge

and to develop hedging opportunities.

Another factor that leads to excessive risk taking are moral hazard problems linked to expected

government bailouts (Goldstein, 2004). Increasing borrower�s participation in losses incurred will

provide incentive not to take unnecessary risks. The government also can help to reduce currency

mismatches in other areas directly and indirectly, by trying to reduce the share of own foreign

denominated debt, by encouraging the development of domestic financial markets, by easing the

24 See, for example, Hausmann, Panizza and Stein (2000), Eichengreen et al. (2002). 25 For a detailed discussion of the drawbacks of original sin as measure of currency mismatch see Goldstein (2004).


40

entry for foreign banks, and by providing the private sector with incentives to reduce the amount

of foreign liabilities. Additionally, limiting fiscal deficits will also help, as high fiscal deficits

increased the perceived likelihood of a devaluation and thereby shy investors away from local

currency financing methods (Goldstein, 2004).

Another measure to reduce currency mismatch would be a closer supervision of banks including

prudential measures, such as limits on foreign exchange liabilities to limit their potential currency

mismatch, as well as regulations to carefully monitor and limit the exchange rate exposure of their

clients (IMF, 2003a).

There is also a role for the IMF or other financial institutions in reducing currency mismatches, as

they could monitoring currency mismatches and could condition loans to a certain threshold or the

reduction of currency mismatch (Goldstein, 2004).

Empirical evidence by Goldstein (2004) suggests that most emerging market economies have

been successful in reducing their aggregate currency mismatches26. Especially Asian economies

display a markedly lower level of currency mismatch than before the outbreak of the Asian crises.

However, especially in Latin America the level of currency mismatch, although reduced, remains

relatively high (Goldstein, 2004).

A number of factors seem to contribute to this positive development in emerging markets. The

supervision and regulation of the banking/financial sector has seemed to improve. Many

governments were able to reduce the amount of foreign currency in public debt (Goldstein, 2004,

table 7). The stock of foreign reserves in emerging markets has risen significantly and is more

than double as high as a decade ago (IMF, 2003). International banks have seemed to change their

lending patterns to and in emerging markets, as indicated by the decreasing share of foreign

currency cross-border bank loans and the concomitant increase of lending by local branches in

local currency (IMF, 2004). The rapid development of financial markets in recent years, which

was aided by improved inflation performances, has increased the supply of local denominated

finance and thus the ability of emerging markets to service debt in their own currencies as well as

the ability to hedge potential mismatches (Goldstein, 2004, table1, 2, 4). Domestic bond markets

have become the largest source of financing for emerging markets and the rise of domestic bond

finance in emerging markets has coincided with a decline of funding through international bonds

(IMF, 2003a. However, while emerging markets are undoubtedly catching up in terms of financial

development, most emerging financial markets are still a long way from displaying the liquidity

and maturity of their industrial counterparts. Moreover, there are very significant cross-country

differences in the development status and in many emerging markets it will still be difficult to find

hedging instruments at reasonable costs (Goldstein, 2004).

26 Measured as short-term external debt to foreign exchange reserves.


41

Authorities seem to have realized the potential threat arising from currency mismatches and have

accordingly increased their efforts to prevent such mismatches from happening. Preliminary

results are hopeful, however, currency mismatches could and probably will remain a lurking

threat to the financial system and to the conduct of monetary policy for some time. Empirical

results show that dollarization is not the only solution to the currency mismatch problem and that

sound monetary and fiscal policies along with financial market development, which is heavily

influenced by the policies, are the fundamentals for controlling currency mismatch. If an economy

faces widespread currency mismatches it seems logical that it will be reluctant to tolerate

exchange rate swings that could possibly trigger a financial crisis. Indeed, empirical researches

indicate that currency mismatches, or measures related to currency mismatch such as original sin

and liability dollarization, increase the probability of limiting exchange rate swings27. However,

as currency mismatches are brought under better control, flexible exchange rates become more

attractive as monetary policy is more effective and less diverted to exchange rate considerations

(Goldstein, 2000).

5.6. Fear of Floating

In contrast to developed countries, empirical evidence suggests that emerging market economies

assign a higher priority to a stable exchange rate (Hausmann et al., 2000, Calvo and Reinhart,

2002). The reluctance of emerging market economies classified as flexible regimes to let their

exchange rates swing has been termed �fear of floating� by Calvo and Reinhart (2002). In their

paper of the same name, the authors analyze the behavior and development of exchange rates,

interest rates and foreign reserves in 155 exchange rate regimes. Their results contradict

predictions of conventional economic theory. Despite having higher inflation rates than their

industrial counterparts and being subject to large shocks, emerging market economies did not

display the exchange rate variability one would expect; exchange rate variability in more than

80% of emerging markets with announced flexible regimes, i.e. managed floats and free floats,

was lower than in comparable developed economies, while reserve and interest rate fluctuations

also were above the average level of industrial economies (table 11). Furthermore, countries with

flexible regimes (developed and developing) displayed higher interest rate variability than more

rigid regimes, while the variability of foreign reserves does not differ significantly from that of

less flexible regimes. Empirical results of Hausmann et al. (2000) point in the same direction.

Thus, reviewing the empirical evidence, 2 important conclusions emerge. First, emerging market

27 See, for example, Calvo and Reinhart (2002), Levy-Yeyati and Sturzenegger (2004), and Eichengreen, Hausmann, and Panizza (2002).


42

economies deliberately use foreign reserves and the interest rate as a policy instrument to stabilize

the exchange rate. However, higher interest rate volatility can also be the result of floating

regimes with an inflation target (Calvo and Reinhart, 2002). Second, the official announcement of

the exchange rate regime is not necessarily a good indicator of actual exchange rate behavior in

developing economies, with many de jure floats and managed floats resembling limited flexibility

arrangements and pegs in practice.

Using the methodology of Calvo and Reinhart (2002) I review if emerging markets are still

displaying a fear of floating for the time period from January 2002 until September 2005 (table

12). The results suggest that the exchange rate behavior of emerging market economies, with the

exceptions of Chile and Brazil, has not changed much. Remarkable is the dramatic decline in the

volatility of nominal interest rates. However, this effect is certainly a consequence of the vastly

improved inflation performance.

It is obvious that emerging markets are deliberately limiting their exchange rate exposure.

Likewise, it is equally or even more evident that emerging markets and developing countries are

more vulnerable to large exchange rate fluctuations. Some of the factors causing this increased

vulnerability, such as, credibility concerns, exchange rate pass through and inflation, currency

mismatches, financial fragility and underdeveloped financial markets, as well as fiscal

imprudence, can be alleviated with the development of good policies and institutions. Other

factors, however, such as openness, trade patterns, and relative economic size are likely to remain

(Ho and McCauley, 2003). Thus, exchange rate considerations will always remain a concern for

monetary policy in emerging markets. However, as policies and institutions in emerging markets

improve, so will the benefits floating exchange rates can provide.

6. Development of Institutions

6.1. Financial Institutions The development of financial markets is essential to emerging market economies as it can

provide some extent of relief from many problems these countries face. As mentioned further

above, deeper and more liquid domestic financial markets are associated with a greater supply

of local currency finance, which reduces the need for foreign currency funding, and an

increased number of hedging tools, both of which help to control the currency mismatch

problem (IMF, 2003a). Deeper local financial markets also mitigate the funding problem

caused by sudden stops and longer maturities on domestic debt reduce the volatility of capital


43

flows by providing international investors with an alternative to short-term financing, such as

bank deposits that can be easily and quickly reversed (Turner, 2002). Well-developed and

well-functioning debt markets also facilitate the conduct of monetary policy (Turner, 2002).

Interest rates will give a more accurate picture of the true opportunity costs, which will

certainly be conducive to investment, and possibly make it somewhat easier to control by the

monetary authorities. Additionally developments in long-term interest rates give the domestic

monetary authority important information about the public�s expectations of future events and

their reactions to past events.

Table 1: Foreign Exchange and Derivatives Markets in Emerging Markets

foreign exchange turnover a

(daily averages in millions of US$) OTC FX derivatives b

(daily averages in millions of US$) country 2001 2004 2001 2004 Latin America Brazil 5239 4344 2126 2278 Chile 2282 2355 632 933 Colombia 371 675 82 220 Mexico 10086 20312 5207 9978 Peru 203 256 36 42 Asia China 95 1742 56 961 India 2840 6066 1627 3385 Indonesia 552 2051 314 1323 Korea 9757 21151 4230 11561 Malaysia 923 1077 730 720 Philippines 502 765 304 428 Thailand 1859 3492 1344 2529 EMEA Czech Republic 2234 2813 1560 2183 Hungary 197 3625 37 2956 Israel 506 3271 n.a. 2274 Poland 6325 7031 4092 5731 Russia 4282 12208 52 1869 South Africa 11327 13656 9735 11591 Turkey 433 1991 177 1226 Advanced Countries Australia 49653 97123 39817 78700 New Zealand 6725 17661 5644 14534 Sweden 30146 40639 24842 32757 a. sum of spot transactions, forwards, and foreign exchange swaps. b. sum of forwards, foreign exchange swaps, and options. Source: BIS, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2001 and 2004.


44

Figure 6: Development of Debt Securities Figure 7: Domestic Debt Securities in in Emerging Markets Advanced Countries and Emerging Markets

Domestic Debt Securities in 2004

(in % of GDP)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Advanced Countries Emerging Marketssource: BIS Quarterly Review , Sep. 2005

In recent years the development of financial markets in emerging markets has made

significant progress, as displayed by the growth of domestic bond and foreign exchange

markets.

Domestic bond markets have grown rapidly throughout all regions28 (figure 6), especially in

the last 4 years. However, among emerging markets there are significant cross country

differences in the size of markets. Countries like Korea and Malaysia display large bond

markets that reach levels of advanced countries. On the other hand, economies like Peru and

Russia have domestic bond markets that are practically nonexistent. Overall, emerging bond

markets are catching up rapidly compared with advanced economies29 (not including the USA

and Japan) in terms of size and liquidity, however, the latter are for the moment still on

average twice as large in terms of domestic debt securities relative to GDP (figure 7).

Much like bond markets, domestic foreign exchange markets in emerging economies have

grown rapidly, and concomitantly with this development, hedging instruments have become

more widely available (table 1).However, cross country differences in the size of foreign

exchange markets are significantly larger than for bond markets. Moreover, in contrast to bond

28 See also table 4 and 5 in the annex. 29 Advanced economies do not include Japan and the USA, see table 6 in the annex.

Domestic Debt Securities (in % of GDP)

15%20%25%30%35%40%45%50%55%

1995 1997 1999 2001 2003Latin America AsiaEMEA EM average

source: BIS Quarterly Review , Sep. 2005


45

markets, the size and liquidity of emerging foreign exchange markets are still very far away

the levels small floating advanced economies display. Nonetheless, the high growth rates in

foreign exchange turnover of emerging markets are positive and are very likely to persist, as

the foreign exchange markets of many countries are still relatively young and at the beginning

of their development.

A healthy financial system also is essential to the macroeconomic stability of a country and to

the conduct of an efficient monetary policy. Weak regulation and supervision of the financial

system can result in weak performances of banks, possibly precluding an expansionary course

of domestic monetary authority for fear of weakening the stability of the financial system. A

weak financial system also threatens the fiscal stability as it increases the chances of a

financial crisis and hence the likelihood that the government will have to perform some sort of

bailout.

Figure 8: % of Nonperforming Loans in Figure 9: % of Nonperforming Loans in Emerging Markets Advanced Countries and Emerging Markets

% of Nonperforming Loans in 2004

0

2

4

6

8

10

1Advanced Countries

Emerging Markets

source: IMF Global Financial Stability Report

The ratio of nonperforming bank loans to total bank loans serves as an indicator of the

soundness of the financial system. As emerging markets consist of a very heterogeneous group

of economies, it is not surprising to that there are very vast differences in this area30 (table 8).

30 See also table 6 in the annex.

% of Nonperforming Loans in EMs

0

5

10

15

20

25

1998 1999 2000 2001 2002 2003 2004Latin America AsiaEMEA EM average

source: IMF Global Financial Stability Report, Sep. 2005


46

While regulation seems to be very strict and effective in Chile (1.2% in 2004) in the

Philippines and Egypt every fourth bank loan results in a default. The average ratio for

emerging markets as a whole fell from 13.8% in 2002 to 9.4% in 2004 with only 2 out of 24

economies failing to lower their ratio during that time period. Moreover, compared with 1998

all regions have lower levels of nonperforming loans. Asian economies display the most

significant decrease, as initial levels in 1998 were very high following the Asian crisis.

Temporary increases in Latin America and in Europe, the Middle East and Africa, have their

roots in the crises faced by Argentina and Turkey.

As financial development and supervision in emerging market economies increases and

improves, so will the case for floating (Mussa et al., 2000, Rogoff et al., 2003). The growth of

local currency finance decreases the costs of flexibility by lowering currency mismatches.

Moreover, flexible exchange rates will become increasingly appealing as they provide a larger

degree of monetary independence as well as improved insulation from negative shocks. At the

same time, financial market development will complicate sustaining an exchange rate peg, as

higher integration with global financial markets and exposure to capital flows will render

emerging markets increasingly vulnerable to changes of market sentiment and will augment

the costs of keeping a peg, as emerging markets will be required to hold a higher level of

reserves.

Recent positive developments in the financial sectors of emerging markets suggest that

while their financial markets do not have the ability of advanced countries to deal with

exchange rate swings, there is nonetheless greater scope for exchange rate flexibility compared

to a few years ago.

6.2. Monetary and Fiscal Institutions

Measuring the credibility of monetary institutions is a difficult task as credibility hinges on the

expectations of the public and cannot be directly measured in numbers. However, with price

stability emerging as the primary objective of monetary policy worldwide, the rate of inflation is a

good indicator of the credibility of monetary institutions.

Likewise measuring the credibility and the �strength� of fiscal institutions is not easy, as fiscal

deficits depend on the cyclical situation of a country and large fiscal deficits are not necessarily an

indicator of weak financial institutions, otherwise the United States would have to be considered as

a country with very weak fiscal institutions. However, in emerging markets large fiscal deficits are


47

a better indicator for financial weakness, and analog to Masson et al. (1997) the use of seigniorage

can be viewed as an indicator for the presence of fiscal dominance.

Figure 10: Inflation in Emerging Markets

CPI Inflation (in %, yoy)

0

10

20

30

40

50

Latin America 214,7 286,6 8,3 6,9

Asia 8,2 8,1 3,3 4,4

EMEA 36,2 42,6 9,2 4,9

80-89 90-99 00-03 2004

source: IMF International Financial Statistics

In the past decade, inflation rates in emerging markets have come down dramatically, especially

in Latin America (figure 10 and table 2). As of 2004, Venezuela and Russia are the only countries

to be in double digits. The results suggest that the credibility of emerging markets towards price

stability has largely increased and is a less relevant issue than a couple of years ago.

Likewise the importance of seigniorage and the associated risk of fiscal dominance seem to be

much less of an issue than in the past (table 2).

The development of fiscal balances on average has been positive, however, the only region

displaying significant progress is Latin America. Moreover, in India the large fiscal deficit seems

to be a potential threat, while the Eastern European economies, which joined the EU recently, also

have been coping with large deficits in recent years.

Positive fiscal performances are crucial to emerging markets in order to contain or even reduce

the burdens of public debt, which are very high in emerging markets and now exceed levels in

advanced countries (IMF, 2003b). High levels of debt constrain the ability of emerging markets to

conduct an independent monetary policy and pose a threat to macroeconomic stability, as their

smaller financial markets are less able to cope with changing market sentiments. The fiscal results

in table 2 do not reveal the whole truth, however. The improvement in emerging markets� fiscal

balances in recent years has coincided with surpluses in the primary balance and slight reductions

in the ratio of debt to GDP of many economies (Krueger, 2005, figure 11, table 7). Moreover,


48

several countries have reduced the vulnerability of their debt structures to exchange rate risk by

moving towards local currency denomination (IMF, 2005a).

Table 2: Inflation, Fiscal Balances, and Seigniorage in Emerging Markets

country 80-89 90-99 00-03 2004 80-89 90-99 00-03 2004 80-89 90-99 00-03 2004Latin AmericaArgentina 565,7 252,9 9,3 4,4 -3,7 -1,1 -1,7 2,1 8,8 1,0 2,4 2,3Brazil 319,1 843,3 9,3 6,6 -8,7 -6,0 -4,2 -2,6 4,2 4,6 2,4 1,2Chile 21,4 11,8 3,2 1,1 0,3 1,3 -0,5 2,0 0,6 0,8 0,0 0,7Colombia 23,5 22,2 7,7 5,9 -1,7 -2,6 -5,8 -4,5 2,2 1,3 0,8 1,0Mexico 69,0 20,4 6,4 4,7 -8,5 0,0 -1,2 -1,0 4,2 1,0 0,8 1,1Peru 481,3 807,9 2,0 3,7 -4,3 -3,1 -2,4 -1,3 6,8 3,6 0,3 0,6Venezuela 23,0 47,4 20,6 21,7 -1,0 -1,4 -3,5 -2,9 1,3 2,6 1,4 2,5Latin America 214,7 286,6 8,3 6,9 -3,9 -1,8 -2,7 -1,2 4,0 2,1 1,2 1,3AsiaChina 7,5 7,8 0,3 4,0 -0,3 -2,2 -3,2 -1,5 4,9 6,6 4,7 5,3India 9,1 9,5 4,0 3,8 -0,7 -7,4 -10,0 -9,3 2,0 1,8 1,3 2,1Indonesia 9,6 14,5 8,4 6,2 -0,2 0,1 -1,3 -1,1 0,8 1,6 1,2 2,1Korea 8,4 5,7 3,2 3,6 -0,2 -1,0 1,7 2,3 0,9 0,5 0,5 -0,3Malaysia 3,7 3,7 1,5 1,5 -0,7 -0,4 -5,6 -4,2 1,1 2,0 -0,1 1,0Pakistan 7,3 9,7 3,4 7,4 -0,6 -7,3 -3,8 -2,8 2,1 2,0 1,6 2,7Philippines 14,2 9,1 4,3 6,0 -0,1 -1,2 -4,5 -3,9 2,2 1,7 -0,1 0,4Thailand 5,8 5,0 1,4 2,8 -0,4 1,4 -1,4 0,0 0,9 1,6 0,6 2,6Asia 8,2 8,1 3,3 4,4 -0,4 -2,3 -3,5 -2,6 1,9 2,2 1,2 2,0EMEACzech Republic n.a. 8,1 2,6 2,8 n.a. -0,4 -6,8 -3,4 n.a. 1,9 -1,8 0,4Egypt 17,4 10,5 3,0 11,3 -7,9 -1,2 -2,0 n.a. 5,4 3,1 5,3 5,9Hungary 9,0 22,2 7,2 6,8 -1,5 -4,7 -5,4 -6,3 -0,3 1,7 0,8 1,0Israel 129,7 11,2 2,1 -0,4 -11,9 -3,3 -2,7 -3,4 2,1 2,0 -0,8 -2,7Jordan 7,0 5,1 1,5 3,4 -7,0 -0,5 -2,2 n.a. 3,6 3,3 1,2 n.a.Morocco 7,6 4,5 1,6 1,0 -7,6 -2,3 -4,1 n.a. 1,6 1,6 2,4 3,3Poland 53,1 83,0 4,6 3,6 -1,5 -1,5 -2,9 -3,9 5,9 2,6 0,4 0,4Russia n.a. 194,5 17,9 10,9 n.a. -4,9 2,4 4,9 n.a. 2,1 3,6 2,8South Africa 14,6 9,9 6,5 1,4 -3,3 -4,7 -1,3 -2,5 0,6 0,5 0,5 1,0Turkey 51,3 77,2 44,9 8,6 -3,1 -6,6 -13,3 -4,9 3,6 3,1 2,3 2,0EMEA 36,2 42,6 9,2 4,9 -5,5 -3,0 -3,8 -2,8 4,8 2,2 1,4 1,6

CPI Inflation (in % yoy) Fiscal Balance (in % of GDP) Seigniorage a (in % of GDP)

a. Defined as the annual change in reserve money divided by nominal GDPsources: IMF International Financial Statisitcs, Deutsche Bank Country Infobase Online, www.latin-focus.com


49

Figure 11: Public Debt in Emerging Markets

Public Debt (in % of GDP)

25

35

45

55

65

75

97 98 99 00 01 02 03 04

Latin America Asia EMEAsource: IMF International Financial Statistics, Deutsche Bank

Sovereign credit ratings also are a good indicator of the quality of a country�s institutions, as

they take a number of factors into account, such as the economic and political structure,

macroeconomic policies, the level of debt and its composition, the level of reserves, and other

factors that that strengthen or threaten the macroeconomic stability.

Figure 12: Emerging Market Sovereign Credit Figure 13: Local and Ratings Ratings Foreign Currency Credit Ratings

EM Local and Foreign Currency Ratings

98 99 00 01 02 03 04 05

long term local currency long term foreign currency

A-

BBB+

BBB

BBB-

BB+

source: Fitch Ratings

EM Sovereign Credit Ratings (in local currency)

98 99 00 01 02 03 04 05Latin America AsiaEMEA EM average

source: Fitch Ratings

A-

BBB+

BBB

BBB-

BB+

BB


50

Figures 12 and 13 as well as table 10 indicate that since the turn of the century emerging

market credit ratings have improved by roughly one rating point, indicating that risks to

financial stability have declined as a consequence of improving institutions. 31 The results also

reveal a difference in the credit ratings of bonds in foreign currency and those of local

currency bonds, implying that exchange rate variability still poses a threat to emerging

markets. However, foreign currency bonds displayed a bigger improvement in ratings than

local currency bonds, suggesting that emerging markets have improved their currency

mismatch position and/or reduced their vulnerability to exchange rate swings. The figures

also display the vast differences in credit ratings between Latin America and the other 2

regions, which is basically a reflection of the economic and financial indicators reviewed in

this chapter. In Asia, credit ratings for Malaysia and Korea have reached the levels they had

before the Asian crisis, while Indonesia has not been able to rebound yet. The experiences of

Asian economies and their credit ratings also reveal a weakness of credit ratings, as they seem

to be backward-looking and do not seem to be able to fully assess the risks to financial

stability. But, much like emerging markets, it is assumable that credit agencies have learned

from past mistakes and are more cautious in gauging credit risks. However, credit risks will

probably never be perfect, but they are nonetheless a good indicator of credit risks to an

economy, which are influenced by its policies and its institutions.

31 On the improvement of emerging market credit quality see also the IMF (2005a).


51

7. Conclusions A key distinction between industrialized and emerging economies is that the latter are more

vulnerable to exchange rate variability. The causes for this vulnerability are not the same

among the group of emerging market economies. In Latin America the main reasons for this

finding have been weak monetary and fiscal policies in the past. In contrast, Asian economies

have a history of relative sound policies, but their financial crises were in part caused by poor

financial supervision and fixed exchange rates, contributing to the build-up of large currency

mismatches.

As mentioned in the introduction, it is mainly the characteristics of a country that determine

which exchange rate regime is best suited to its needs. In the past years, the characteristics of

emerging market economies have been changing. The most remarkable development is

undoubtedly the significant lowering of inflation, which suggests that the credibility of

monetary institutions towards price stability has increased. In this sense, the main argument

for fixing the exchange rate, namely the ability to import monetary credibility and lower

inflation, is becoming a less relevant issue for emerging markets. Moreover, the combination

of a credible monetary policy and floating exchange rates may increase the effectiveness of

monetary policy by reducing credibility related effects, such as a high pass through, wage

indexation, and dollarization. The recent decline in inflation has coincided with a rapid

development of domestic financial markets, a better supervision of the financial sector, and

improved fiscal performances. While exchange rate fluctuations undoubtedly still pose a

threat to emerging market economies, the recent developments in the financial sector have

increased the availability of financing methods in local currency, thereby reducing the risk

associated with exchange rate flexibility. Overall, the improvements in the quality of

institutions and the decline in vulnerability to exchange rate swings strengthen the benefits of

floating exchange rates, as there is an increased scope for monetary policy due to the decline

of exchange rate and fiscal considerations (Rogoff et al., 2003, Calvo and Mishkin, 2003).

While the quality of institutions has undoubtedly improved, there remain country specific

structural factors influencing exchange rate behaviour that cannot be altered (Ho and

McCauley, 2003). In this sense, exchange rate considerations are of greater importance for

small and open countries as well as economies that have large trade ties with a single country

or currency area.


52

The recent improvement of institutional quality in emerging markets has coincided with a

move towards more flexible regimes and inflation targeting in many countries (Hakura,

2005). However, most floating economies still display a fear of floating (table 12).

Considering the fact that floating monetary frameworks have not been in place for a very long

time and that most economies do not have experience in successful floating, it may take some

time until emerging markets feel comfortable enough to allow substantial exchange rate

variability (Rogoff et al., 2003). Nonetheless, as Rogoff et al. (2003) note, there is reason to

believe that emerging markets will learn how to float.

Exchange Rate Regimes for Emerging Markets Annex

53

Annex

Table 3: Openness of Emerging Market Economies

Openness a (in % of GDP) country 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Latin America Argentina 10 11 12 12 11 12 11 21 20 20 Brazil 9 8 9 9 11 12 14 14 15 20 Chile 30 30 30 30 26 30 34 32 35 35 Colombia 18 18 18 18 18 21 22 21 22 20 Mexico 29 31 30 32 32 32 29 28 29 31 Peru 16 16 17 16 16 17 17 17 18 19 Venezuela 25 29 25 21 19 22 20 23 23 27 Asia China 23 20 21 20 21 25 24 28 33 40 India 12 12 12 12 13 15 14 16 15 16 Indonesia 27 26 28 48 32 38 39 33 29 29 Korea, 30 30 33 40 36 40 37 35 37 37 Malaysia 96 91 93 105 109 114 107 106 104 111 Pakistan 18 19 19 17 16 17 19 19 20 22 Philippines 40 45 54 56 51 54 51 49 50 54 Thailand 46 43 48 51 52 63 63 61 63 63 EMEA Czech Republic 53 53 56 56 57 66 68 63 64 n.a. Egypt 25 23 23 22 20 20 20 20 23 27 Hungary 44 48 55 64 67 77 75 67 n.a. n.a. Israel 38 37 36 36 40 43 39 42 41 n.a. Jordan 63 66 61 55 52 55 56 56 58 57 Morocco 31 28 30 30 32 35 35 36 34 35 Poland 24 25 26 29 28 31 30 30 24 25 Russia 28 24 24 28 35 34 31 30 27 23 South Africa 23 24 24 26 25 28 29 32 27 27 Turkey 22 25 28 26 25 28 33 30 30 28 a. Measured as the average of exports and imports in percent of GDP. Source: World Bank, World Development Indicators database


54

Table 4: Domestic Debt Securities in Emerging Markets

Domestic Debt Securities (in billions of US dollars) country 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Latin America Argentina 25,7 29,2 34,4 40 42,5 47 37,4 18,2 22,1 24,3Brazil 231,2 296,6 344,5 390,8 293,9 298,3 311,5 211,6 299,9 371,6Chile 28,6 32,3 36,5 33,8 33 34,9 34,7 34,6 40,8 41,8Colombia 6,3 8,3 9,7 11,3 13,5 16,8 19,6 19,5 22,9 30,2Mexico 24,1 26,9 40,8 40,4 59,4 87,3 129,5 133,3 147,7 176,9Peru 1 1,3 1,9 2,1 3 3,6 4,1 4 4,9 7,1Asia China 66,8 87,4 116,3 166,5 215 265,6 315,6 377,3 440,4 527,7India 70,6 81,2 75,2 85,7 102,1 113,6 130,1 155,8 196,8 239,2Indonesia 3,1 6,7 4,3 6,4 49,2 53,6 49,2 58,1 65,7 57,9South Korea 227,2 239 130,3 240,1 265,5 269 292,7 380,9 445,5 567,6Malaysia 62,4 73,1 57 61,9 66,1 74,7 82,8 84,4 98,7 110,6Pakistan 22,6 22,3 23,5 26,2 26,8 26,7 26,6 28,4 30,9 31,5Philippines 26,2 27,9 18,4 21 22,4 19,8 20,6 20,9 24 25,2Thailand 15,9 19 10,6 24,5 31,5 31,1 36,2 47,3 58,8 67,2EMEA Czech Republic 10,5 10,7 10,8 20,6 24,3 22,8 25,8 43,8 56,1 65,8Hungary 11,8 15,1 14 15,8 16,6 16,5 19,7 30,8 42,1 52,9Poland 24,9 25,7 25 29 27,3 32,1 44,2 55,3 65,8 95,9Russia 16,5 42,6 64,6 7,7 9,2 7,7 5,3 6,8 10,7 20,1South Africa 97,9 79,4 79,5 68,8 68,5 57,8 38,8 53,5 78,7 104,6Turkey 21,3 26,6 29,7 37,5 43 54,7 84,7 91,8 140,3 169,8Source: BIS Quarterly Review, Sep. 2005


55

Table 5: Domestic Debt Securities in Emerging Markets (in % of GDP)

Domestic Debt Securities (in % of GDP) country 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Latin America Argentina 10,0% 10,7% 11,7% 13,4% 15,0% 16,5% 13,9% 17,9% 17,4% 16,0%Brazil 32,8% 38,3% 42,6% 49,6% 54,8% 49,6% 61,0% 45,9% 59,3% 61,5%Chile 40,1% 42,6% 44,1% 42,6% 45,2% 46,4% 50,6% 51,4% 55,6% 44,4%Colombia 6,8% 8,5% 9,1% 11,5% 15,7% 20,1% 23,9% 23,9% 28,6% 31,0%Mexico 8,4% 8,1% 10,2% 9,7% 12,3% 15,0% 20,8% 20,7% 23,2% 26,2%Peru 1,9% 2,3% 3,2% 3,7% 5,8% 6,7% 7,6% 7,1% 8,1% 10,3%Latin America 21,6% 24,5% 26,8% 29,8% 29,4% 29,1% 33,4% 29,9% 36,3% 38,5%Asia China 9,5% 10,7% 12,9% 17,6% 21,7% 24,6% 26,8% 29,7% 31,1% 31,9%India 20,0% 21,7% 18,5% 20,9% 23,4% 24,8% 27,6% 31,5% 34,2% 36,0%Indonesia 1,4% 2,7% 1,8% 6,1% 32,0% 32,4% 29,9% 29,0% 27,5% 22,5%South Korea 43,9% 42,8% 24,7% 68,9% 59,6% 52,5% 60,7% 69,5% 73,2% 83,4%Malaysia 70,2% 72,5% 56,9% 85,8% 83,5% 82,7% 94,1% 88,6% 94,9% 93,5%Pakistan 29,8% 29,4% 31,4% 36,2% 37,2% 36,1% 38,3% 36,6% 34,4% 30,5%Philippines 34,7% 33,1% 22,0% 31,5% 29,4% 26,5% 29,4% 27,6% 30,8% 29,7%Thailand 9,5% 10,4% 7,0% 21,9% 25,7% 25,3% 31,3% 37,3% 41,1% 41,1%Asia 22,5% 22,8% 17,6% 29,7% 32,7% 33,1% 36,2% 39,9% 41,8% 43,7%EMEA Czech Republic 18,6% 17,1% 18,8% 33,4% 40,8% 40,9% 42,4% 59,4% 61,9% 61,5%Hungary 26,4% 33,4% 30,6% 33,6% 34,6% 35,4% 38,0% 47,5% 51,3% 52,7%Poland 18,3% 16,7% 16,3% 17,2% 16,6% 19,3% 23,8% 28,9% 31,4% 39,6%Russia a 5,3% 10,9% 16,0% 2,8% 4,7% 3,0% 1,7% 2,0% 2,5% 3,5%South Africa 64,8% 55,2% 53,4% 51,3% 51,5% 43,5% 32,7% 48,3% 47,6% 49,1%Turkey 12,8% 15,0% 16,0% 19,0% 23,7% 27,6% 59,2% 50,2% 58,3% 56,1%EMEA 30,0% 27,0% 26,9% 28,2% 30,6% 30,6% 38,1% 44,1% 48,6% 50,7%EM average 23,2% 23,9% 22,0% 29,5% 31,4% 31,4% 35,5% 37,6% 41,3% 43,4%a. Russia is not included in the averages of EMEAs and total EMs for reason of distortion. Note: GDP measured at current prices. Sources: BIS Quarterly Review, Sep. 2005 and IMF WEO database


56

Table 6: Domestic Debt Securities in Advanced Countries in 2004

advanced countries

country debt (in billions of US$) debt (as % of GDP)

2004 Australia 358,7 58,0%Austria 226,3 76,8%Belgium 475,9 135,1%Canada 758,7 76,4%Denmark 462,3 191,3%Finland 122,9 66,0%France 2127,9 104,0%Germany 2226,1 80,8%Greece 217,5 105,8%Iceland 25,5 208,0%Ireland 90,9 49,2%Netherlands 685,1 112,8%New Zealand 24,7 25,5%Norway 107,4 42,8%Portugal 151,3 90,1%Singapore 66,3 62,1%Spain 872,1 83,7%Sweden 311,7 89,8%Switzerland 259,4 72,5%United Kingdom 1040,8 48,8%average 530,6 81,6%Japan 8857,9 189,6%United States 18967,9 161,6%Total average 1747,2 130,7%Note: GDP measured at current prices. Sources: BIS Quarterly Review, Sep. 2005 and IMF WEO database.


57

Table 7: Public Debt in Emerging Markets

Public Debt (in % of GDP) country 95 96 97 98 99 00 01 02 03 04Latin America Argentina 34,4 36,4 35,4 38,2 43,5 45,6 53,7 134,6 138,1 121Brazil 38,9 41 41,2 55,5 79,2 74,1 70,6 72 78,3 71,8Chile 57,3 53,3 53 48,7 48,8 48,4 49 47,1 42,7 35,5Mexico 42,9 36,2 37,1 41,2 42,8 40 40,5 40,9 41,6 38,3Venezuela 30,3 29,3 27,6 30,5 39,1 47,6 39,4Latin America 43,4 41,7 41,7 42,8 48,7 47,1 48,9 66,7 69,7 61,2wo Argentina 46,4 43,5 43,8 43,9 50,0 47,5 47,7 49,8 52,6 46,3Asia China 19,3 18,7 18 12,2 10,8 10 8,9 7,7 8,2 8,9India 71,4 67,8 68,3 69,5 69,9 71,7 74,7 79,3 78,5 78Indonesia 15,2 24,7 44,6 86,2 92,9 82,8 84,3 79,2 74,3Korea 7,3 7,5 13,6 30,4 32,3 30,3 36,8 33,3 32,5 31,8Malaysia 53,2 46,8 45,4 55,6 56,2 54,1 43,6 63,6 63 62,5Philippines 75,7 65 64,3 94,7 101,5 108 104,8 110,4 118 111,2Thailand 11,5 14,1 36,9 44 54 57 57,1 53,9 49,4 48,8Asia 39,7 33,6 38,7 50,1 58,7 60,6 58,4 61,8 61,3 59,4EMEA Czech Republic 14,4 12,4 12,2 12,2 13,5 18,2 25,3 29,8 36,8 36,8Hungary 64,2 61,9 61,2 55,4 52,2 55,5 57,4 57,4Israel 100,2 99,4 99 98,9 97,4 89 94,2 103,2 104,2 100,2Russia 40,7 32,8 55 79,4 88,8 56,8 42,9 36,5 26,8 21,7South Africa 51 49,9 49 48,9 46,9 43,3 42,4 36,6 36,4 36,5Turkey 48,2 58,1 62,7 100,8 88,3 79,3 73,8EMEA 51,6 48,6 55,9 58,3 61,0 54,2 59,6 58,3 56,8 54,4Source: Deutsche Bank Country Infobase Online


58

Table 8: Percentage of Nonperforming Loans in Table 9: Percentage of Nonperforming Emerging Markets Loans in Advanced Countries

% of Nonperforming Loans for Emerging Markets country 1998 1999 2000 2001 2002 2003 2004Latin America Argentina 5,3 7,1 16 19,1 38,6 33,6 18,6Brazil 1,5 1,7 8,3 5,6 4,8 4,8 3,9Chile 10,7 13,6 1,7 1,6 1,8 1,6 1,2Colombia 10,7 13,6 11 9,7 8,7 6,8 3,3Mexico 11,3 8,9 5,8 5,1 4,6 3,2 2,5Peru 7 8,7 n.a. 17 14,6 12,2 9,5Venezuela 5,5 7,8 6,6 7 9,2 7,7 2,8average 7,4 8,8 7,1 9,3 11,8 10,0 6,0Asia China n.a. 28,5 22,4 29,8 26 20,4 15,6India 14,4 14,7 12,8 11,4 10,4 8,8 6,6Indonesia 48,6 32,9 34,4 28,6 22,1 17,9 13,4Korea 7,6 11,3 8,9 3,3 2,4 2,6 1,9Malaysia 13,6 11 15,4 17,8 15,8 13,9 11,8Pakistan 19,5 22 19,5 19,6 17,7 13,7 9Philippines 10,4 12,3 24 27,7 26,5 26,1 24,7Thailand 42,9 38,6 17,7 10,5 15,7 12,9 11,9average 22,4 21,4 19,4 18,6 17,1 14,5 11,9EMEA Czech Republic 20,7 21,9 29,3 13,7 10,6 4,9 4,1Egypt n.a. n.a. 13,6 15,6 16,9 20,2 24,2Hungary 8,2 4,6 3 2,7 2,9 2,6 2,7Israel 4,6 4,7 6,9 8,2 9,8 10,5 10,5Jordan n.a. n.a. 18,4 19,3 21 19,9 n.a.Morocco 14,6 15,3 17,5 16,8 17,2 18,1 19,4Poland 10,9 13,2 15,5 18,6 22 22,2 15,5Russia 24,5 21,2 7,7 6,2 5,6 5 3,8South Africa 4,1 4,9 4,3 3,1 2,8 2,4 1,8Turkey 6,7 9,7 9,2 29,3 17,6 11,5 6average 11,8 11,9 12,5 13,4 12,6 11,7 8,8EM average 13,8 14,3 13,7 13,9 13,8 12,1 9,4source: IMF Global Financial stability report, Sep.2005

Advanced Countriescountry 2004Australia 0,3Canada 0,7Japan 2,9United States 0,8Austria 2,2Belgium 2,2Finland 0,4France 5Germany 5Greece 7,1Iceland 0,9Ireland 0,8Italy 6,5Luxembourg 0,3Netherlands 1,8Norway 1Portugal 2,2Spain 0,8Sweden 0,9Switzerland 1,6UK 2,2Hong Kong 2,2Singapore 2,9Slovenia 5,7UAE 12,5Kuwait 5,4average 2,9

source: IMF Global Financial Stability Report, Sep. 2005


59

Table 10: Emerging Market Sovereign Credit Ratings

country 97 98 99 00 01 02 03 04 05 1997 1998 1999 2000 2001 2002 2003 2004 2005AAA 21 Latin AmericaAA+ 20 Argentina a 11 11 11 11 2 3 6 6 6 10 10 10 10 2 2 2 0 2AA 19 Brazil 9 9 7 8 8 7 8 8 9 8 8 7 9 9 7 8 9 9AA- 18 Chile 18 18 18 18 18 18 17 17 17 15 15 15 15 15 15 15 15 16A+ 17 Colombia 15 15 14 13 13 12 12 12 12 13 13 13 11 11 10 10 10 10A 16 Mexico 12 12 12 13 13 13 13 13 13 10 10 10 11 11 12 12 12 12A- 15 Peru 12 12 12 12 11 11 11 11 11 10 9 9 9 9 10 10BBB+ 14 Venezuela 8 8 8 8 8 6 6 8 9 9 9 9 9 9 7 6 8 9BBB 13 average 12,3 12,3 11,8 12,0 11,8 11,2 11,2 11,5 11,8 11,0 11,0 10,7 10,7 10,7 10,0 10,0 10,7 11,0BBB- 12 AsiaBB+ 11 China 16 16 16 16 16 15 15 15 15 15 15 15 15 15BB 10 India 12 11 11 11 11 11 11 10 10 10 11 11BB- 9 Indonesia 16 11 9 6 6 7 8 8 9 12 6 6 6 6 7 8 8 9B+ 8 Korea 20 12 15 16 16 18 18 18 19 17 6 12 14 14 16 16 16 17B 7 Malaysia 15 13 15 15 15 16 16 17 17 11 10 13 13 13 14 14 15 15B- 6 Philippines 13 13 12 12 11 11 11 11 11 11 11 10 10 10CCC 5 Thailand 14 14 14 14 14 15 15 16 11 12 12 12 12 13 13 14CC 4 average 17,0 12,5 13,2 12,7 12,9 13,4 13,6 13,7 14,1 13,8 9,6 11,5 11,7 11,6 12,1 12,3 12,6 13,0C 3 EMEADDD 2 Czech Republic 18 17 17 17 16 16 16 16 17 14 14 14 14 14 14 15 15 16DD 1 Egypt 15 15 15 15 14 13 13 13 13 12 12 12 12 12 11 11 11 11D 0 Hungary 14 16 16 17 17 17 17 17 16 13 13 14 15 15 15 15 15 15

Israel 17 17 17 17 17 16 16 16 16 15 25 15 15 15 15 15 15 15Poland 15 17 17 17 17 17 17 16 16 13 14 14 14 14 14 14 14 14Russia 10 10 5 6 7 9 11 12 13 11 11 5 7 8 9 11 12 13South Africa 13 13 13 14 14 14 15 15 16 10 10 10 12 12 12 13 13 14Turkey 8 8 8 8 6 7 7 8 9 8 8 8 9 7 7 6 8 9average 13,8 14,1 13,5 13,9 13,5 13,6 14,0 14,1 14,5 12,0 13,4 11,5 12,3 12,1 12,1 12,5 12,9 13,4EM average 14,5 13,9 13,5 13,6 13,4 13,4 13,6 13,8 14,2 12,8 12,3 11,8 12,1 12,0 12,0 12,2 12,7 13,1

Emerging Market Sovereign Credit Ratings (Fitch Ratings)long term local currency long term foreign currencyRating

ScaleAssigned

Value


60

Table 11: Fear of Floating (Calvo and Reinhart)

greater than 400 basis points

country Period regime exchange rate reserves nominal interest rateLatin AmericaBrazil July 1994�December 1998 managed float 94,3 51,8 25,9Chile October 1982�November 1999 managed float 83,8 48,2 51,2Colombia January 1979�November 1999 managed float 86,8 54,2 2,9Mexico December 1994�November 1999 float 63,5 28,3 37,7Peru August 1990�November 1999 float 71,4 48,1 31,4AsiaIndia March 1993�November 1999 float 93,4 50 23,8Indonesia November 1978�June 1997 managed float 99,1 41,5 5,2Malaysia December 1992�September 1998 managed float 81,2 55,7 2,9Korea March 1980�October 1997 managed float 97,6 37,7 0Pakistan January 1982�November 1999 managed float 92,8 12,1 14,1Philippines January 1988�November 1999 float 74,9 26,1 1,5EMEAEgypt February 1991�December 1998 managed float 98,9 69,4 0Israel December 1991�November 1999 managed float 90,9 43,8 1,1South Africa January 1983�November 1999 float 66,2 17,4 0,5Turkey January 1980�November 1999 managed float 36,8 23,3 61,4Advanced countriesCanada June 1970�November 1999 float 93,6 36,6 2,8Australia January 1984�November 1999 float 70,3 50 0New Zealand March 1985�November 1999 float 72,2 31,4 1,8Source: Calvo and Reinhart (2002)

within a 2.5% band

Probability that the monthly change is


61

Table 12: Fear of Floating 2002-2005

greater than 400 basis points

country Period regime exchange rate reserves nominal interest rateLatin AmericaBrazil January 2002-September 2005 float 44,4 57,8 0Chile January 2002-September 2005 float 62,2 82,2 0Colombia January 2002-September 2005 float 80,0 71,1 0Mexico January 2002-September 2005 float 82,2 77,3 0Peru January 2002-September 2005 managed float 100,0 62,2 2,2AsiaIndia January 2002-September 2005 managed float 95,6 46,7 0Indonesia January 2002-September 2005 managed float 75,6 77,8 6,7Korea January 2002-September 2005 float 80,0 75,6 0Pakistan January 2002-September 2005 managed float 100,0 48,9 0Philippines January 2002-September 2005 float 97,8 73,3 0Thailand January 2002-September 2005 managed float 91,1 77,8 0EMEAEgypt January 2002-September 2005 managed float 88,9 77,8 0Israel January 2002-September 2005 managed float 80,0 86,7 0South Africa January 2002-September 2005 float 35,6 66,7 0Turkey January 2002-September 2005 float 53,3 35,6 2,6Advanced countriesCanada January 2002-September 2005 float 84,4 75,6 0Australia January 2002-September 2005 float 66,7 33,3 0New Zealand January 2002-September 2005 float 57,8 13,3 0Source: IMF International Financial Statistics

within a 2.5% band

Probability that the monthly change is

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Economy & Finance

Exchange Rate Regime for Emerging Markets