The nominal exchange rate is a key adjustment tool to help countries avoid traumatic balance of payments crises. And when a country is in a crisis, external adjustment is delayed and more difficult under a pegged exchange rate regime. These are the central findings of research by Atish Ghosh, Mahvash S. Qureshi and Charalambos G. Tsangarides, published in the January 2019 edition of The Economic Journal.
The researchers have built a unique and comprehensive dataset of bilateral exchange rate regimes covering 181 countries over the past 30 years, which takes account of the key fact that the degree of exchange rate flexibility across various trading partners. Analysis of these data confirms that trade imbalances under less flexible exchange rate regimes adjust much more slowly than trade imbalances under floating rates.
The importance of exchange rate flexibility in facilitating the adjustment of external (trade or current account) imbalances has been at the centre of policy debates for several years now.
Prior to the global financial crisis, the debate focused on global imbalances and the role played by the exchange rate policies of several surplus countries in perpetuating those imbalances. After the crisis, the challenges confronting many eurozone periphery countries have rekindled interest in the relationship between exchange rate flexibility and external adjustment – on the sides of both deficit and surplus countries.
Is there a connection between exchange rate regimes and external adjustment? Writing in the heyday of Bretton Woods, Friedman (1953) argued that flexible exchange rates would facilitate external adjustment, thus helping countries avoid traumatic balance of payments crises: in deficit countries, the exchange rate would depreciate, restoring competitiveness and narrowing the deficit; in surplus countries, the exchange rate would appreciate, shrinking the surplus.
By contrast, under a fixed exchange rate, the burden of adjustment in deficit countries would fall entirely on downwardly rigid prices of goods and factors, while surplus countries would face no compelling adjustment mechanism.
What does the evidence say? The emerging market financial crises of the 1990s – all of which occurred under some form of pegged exchange rate regimes – the large current account deficits in East European countries in the run-up to the global financial crisis, and the continuing efforts of several eurozone peripheral countries are all testament to the delayed and more difficult external adjustment under pegged exchange rates.
Yet formal evidence on the link between the exchange rate regime and external adjustment is surprisingly scant and contradictory – with several studies finding no such relationship.
This research argues that the main reason existing studies do not find an empirically robust relationship between exchange rate flexibility and external adjustment is because they use exchange rate regime classifications that are aggregate in nature, and do not differentiate between the degree of exchange rate flexibility across various trading partners.
To put this in perspective, consider the example of the United States. Clearly, the US dollar floats – and existing exchange rate regime classifications characterise it as such. Yet its exchange rate against many of the major trading partners (for example, China) and that is relevant to the dynamics of a significant portion of its trade balance, does not adjust freely.
A similar problem arises for the eurozone countries: existing exchange rate regime taxonomies classify them as either having floating exchange rates (but around 60% of their trade is with each other) or as having fixed exchange rates (but 40% of their trade is with countries against which they float).
To test this hypothesis, the researchers propose a novel way to examine the regime-external adjustment nexus through the prism of bilateral relationships between pairs of countries. For this purpose, they construct a unique and comprehensive dataset of bilateral exchange rate regimes covering 181 countries over 1980-2011.
Allowing for heterogeneity of exchange rate relationships across trading partners, they find that trade imbalances under less flexible exchange rate regimes adjust significantly more slowly than imbalances under floats. For example, the half-life of shocks to the trade balance is almost twice as long under fixed regimes as compared with floats when both the cross-sectional and time variation in the data are taken into account, and about 0.3 years longer when only the time variation is considered.
These results thus strongly support Friedman’s hypothesis, and highlight the importance of the nominal exchange rate as an important adjustment tool.
‘Friedman Redux: External Adjustment and Exchange Rate Flexibility’ by Atish Ghosh, Mahvash S. Qureshi and Charalambos G. Tsangarides is published in the January 2019 issue of The Economic Journal.
Deputy Division Chief within the International Monetary Fundâ€™s research department
Deputy Division Chief within the International Monetary Fundâ€™s African Department