On a comprehensive case for Managed Floating for Thailand:

How much “managed” and how much “floating”?

Ashvin Ahuja25 February 2004

Disclaimer

The views expressed herein are those of the author’s and not necessarily

those of the Bank of Thailand.

3

Motivation and Policy Question

• External and domestic stability strong today • Exchange rate regime is our choice rather than

forced on us

• What is the appropriate exchange rate regime for Thailand going forward?

4

Outline of Presentation

1. Available choices

2. Evaluation criteria & highlights of findings

3. Fix-Flex, LT output growth & price stability

4. Fix-Flex & ST (business cycles) shock absorbance

5. Credibility and loss of independent MP

6. Support for Adjustable Band & Basket + IT

1. Available Choices

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What are our choices?

Classification of Exchange Rate Regimes (IMF)

1. Exchange arrangement with no separate legal tender2. Currency board arrangement3. Conventional pegged arrangement4. Pegged exchange rate within horizontal bands5. Crawling peg6. Crawling band7. Managed floating with no pre-announced path for the

exchange rate8. Independently floating

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2. Currency union

EXCHANGE RATE REGIMES

Fixed Regimes Flex/Floating Regimes

1. Formal dollarization

No separate legal tender

12. Other managed float with no predetermined exchange rate path1

13. Independently floating

1Excludes tightly managed floats3. Currency board

arrangement

Intermediate Regimes

Soft peg

Conventional fixed pegs Crawling pegs Crawling bands

7. Forward-looking

11. Tightly managed float

10. Backward-looking

9. Forward-looking

8.Backward-looking

6. Horizontal bands

5. Vis-à-vis a basket

4. Vis-à-vis a single currency

2. Evaluation Criteria & Highlights of Findings

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Our Evaluation Criteria

1. DesirabilityA. Long-term growth and price stability

performance

B. Short-term output variation

2. Feasibility or regime credibility

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Highlight of results

• Free Floats & Limited Flex associated with best LT growth and inflation performance, on average

• For Thailand, Fix-Flex hybrid absorbs shocks better than either extreme

• Fix can be too costly for Thailand—loss of monetary policy independence highly costly & so Fixing credibly harder

Therefore, find a credible hybrid• Support for NEER to float within wide/adjustable band,

all unannounced, (ABB) + Inflation Targeting for Thailand.

3. Fix-Flex, LT Output Growth and Price Stability

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Fix-Flex, LT growth and inflation

• Common wisdom based on de jure classification:

Economies with Freely Floating perform worst in both

growth (0.5% per capita) and inflation (174%) dimensions,

on average.

• Reinhart & Rogoff (2002): (1) Identifying de facto exchange

rate arrangements—full IMF sample; (2) Finds “limited

flexibility” and “freely floating” -- best growth & inflation

performance, on average.

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Important Macroeconomic Statistics Across Regime Types : 1970 -2001

Real GDP Per Capita (PPP) FF > LF MF > Peg > Free Fall

($14,000) ($6,200) ($6,000) ($4,800) ($3,500)

Growth rate RGDP Per Capita FF LF > Peg > MF > Free Fall

(2.4%) (1.8%) (1.6%) (-2.5%)

Inflation FF LF < MF Peg < Free Fall

(<10%) (16%) (443%)

Trade Volume FF < MF < LF Peg > Free Fall

(X+M/GDP) (45%) (60%) (80%) (60%)

≅

≅

≅ ≅

≅

Source : Data from Reinhart & Rogoff (2002)

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Caveat Emptor

• Results may not be robust across methods of classification (de jure v de facto v mixed)– De jure, 136 countries, 1960-90 (Ghosh, et al (1997)):

• Growth rates differ slightly across regime • Inflation lower, more stable under prg• Variability of growth worse under peg

• Cause/effect of good fix and good flex on long-run

growth performance unclear, but non-credible regime

(freely falling/high inflation) associated with pitiful LT

growth performance.

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Caveat Emptor (cont.)

• Fischer (2001) using new IMF’s mixed classification– In 1990s, dramatic shift to “bipolar” both in entire IMF

membership and subgroups of industrial and EMs• Levy-Yeyati and Sturzenegger (2001) and Masson

(2001) using de facto– In 1990s, lots of regime crossing, but no distinct sign of

“bipolar” domination

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Fix-Flex & inflation performance in emerging markets

Common wisdom: EMs usually experience higher ER pass-through (to inflation)—hence Fear of Floating.

• EMs more open. • (Poorer) EMs’ CPI baskets are tradable (foodstuff and

manufacturing) heavy. Rich countries’ baskets dominated by non-tradable services.

• EMs have history of high inflation (esp. Lat Am)

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Thai economy experiences “low” pass-through, even under Flex

• Thai economy quite open (X+M = 110% of GDP). Unclear relationship b/w openness and pass-through (Ho & McCauley, 2003)

• Thai CPI basket domestic, non-tradable goods heavy (Chensawasdijai&Buddhari (2003))

• Smaller amplifier: low πe

• Depends on credibility of CB/fiscal discipline and observed π history (cannot discount role of past Peg).

4. Fix-Flex & ST (business cycles) Shock Absorbance

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Key issues faced by central banks

Stylized Story: Large capital inflows rapid credit expansion,

investment and asset price boom overextension of banks and slowdown in cap inflowRER appreciation reduces export competitiveness, C/A suffers

Finally, reversal of cap flow, asset price & FX collapsebalance sheets destroyed, credit channel blocked.

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Some stylized facts on financial stability

1. Financial crises usually associated w/

– Sharp REER trend swing (appreciation)

– Unexpected collapse of “Fix” – Lat Am and Asia

2. FX volatility associated w/ less short-term capital flow

3. Fact: REER “misalignment”, i.e. persistent appreciation, large capital inflows and C/A deficits

– Also happen under “Flex”: see pre-euro E. Europe, e.g. Czech, Hungary, and Poland, and USA (free float)

– Does not automatically imply financial crisis, see USA

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There are other structural elements to consider

• Potential concern for countries with 1. weak financial infrastructure 2. large degree of currency mismatch (denomination, maturity and liquidity) and 3. low credit rating

• Countries with fin crises have 1-3, are low income countries, so tend to use “Fix”.

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Use Mundell-Fleming Framework to explore issues

• Bare-bones model• Used to organize and analyze issues listed• Analyze which regime fares better under various macro

shocks, both correlated & uncorrelated, and financial sector

• Assume regimes are credible• No explicit welfare evaluation

– See Obstfeld&Rogoff (1998), Bachetta and van Wincoop (…), and Devereux&Engel (…), for new open economy macro approach

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Mundell-Fleming Model: Rank b/w Fix-Flex according to minimum var(GDP)

• Fix or Flex superiority depends on nature of shocks

• Theme: international cap mobility, specifically that capital-flows shocks (relevant after 1990s, e.g., fluctuations in int’l interest rates) take both real and monetary forms

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Examples of shocks and economic interpretations

• Money (stock) shocks – foreign i; money demand (transaction tech, multiplier, portfolio shift); bank runs & sudden bank credit decline

• Real (flow)shocks – productivity changes (can be persistent), government spending (temporary)

• C/A shocks – oil shocks, terms of trade shock• Cap Acct shocks – sudden-stop problem (countries

rationed out of capital market), contagion, herding, movements in international interest rates ( rintl leads to boost in AD and Md; post-financial crisis, both AD and Md fall.) Both real and monetary.

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Examples of shocks• Unanticipated shocks are costly – disrupting production,

affecting factor and output prices, impacting on forex-denominated loans– Example: expecting fixed, but turns out flex

• Herd – rational decision to follow the crowd to make gains or limit losses

• Sunspot – self-fulfilling prophecy in currency attack making it hard to maintain even technically feasible fixed ER

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Shock absorbance: Bare-bones Mundell-Fleming type models

• Static model • Objective: Minimize output fluctuation

– Choice: ER regime– Assuming: random shocks, free cap mobility, sticky

price – 2 markets: domestic output and money

y = αe + u (1)m = y + v (2)

– Fix: e constant; y, m endogenous– Flex: m constant; y, e endogenous

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Fix for big money/ Flex for big real shocks

– Fix: var y = volatility of real shocks (var u); var e = 0 (3)

– Flex: var y = volatility of money shocks (var v); var e = (var u +var v + 2ρσuσv)/α2 (4)

Standard result in literature: If volatility of money shocks larger than real, then Fix is better. If volatility of real shocks larger than money, then Flex is better.

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Some intuition: Monetary shocks

• Fix automatically eliminates real effects from Md shock.– Fix implies CB sets Ms to accommodate Md shocks through

nonsterilized FX intervention (or use Ms to peg home i to foreign i)

• Under Flex, Ms held constant, adjustment needs be made through change in price levels, which if sticky causes prolonged & costly adjustment to new equilibrium.

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Some intuition: Real shocks

• See eq (1), adjustment to new equilibrium immediate under Flex, RER changes through movements in NER—requiring no price changes

• Under Fix, need domestic price to bear all burden of adjusting to new equilibrium, a transition which is costly under sticky price.

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Key issues after crisis faced by Central Banks rephrased

1. Volatility of Capital Flows and RER2. Currency mismatch and financial vulnerability3. Credit channel under systemic bank runs or rapid

disintermediation

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Key Issue 1: Putting weight on RER volatility, (credible) Fix

absorbs capital account shocks better

• Rationale for positive weight on var(RER): Sharp medium-term RER swings behind serious financial difficulties

• Cap Acct shocks are both real (output) and monetary (price) shocks generate positive correlation b/w real and nominal shocks, ρ>0.

• If objective also minimize fluctuation in RER, then the more prominent cap acct shocks, the more attractive moving toward “Fix” is.

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Key Issue 2: Currency mismatch and financial weakness

• Emphasis on large FX loans and cash flow in local currency.

• Under Flex, assuming higher var(e), FXL likely made to hedged or tradable sector, and ER volatility costly to firms, but need not be costly to system. (Discourages mismatch position)

• Under Fix, FXL largely made to unhedged or nontradable sector, if flex happens unexpectedly, then highly costly to system. (Very costly to switch to Flex--assume credible Fix)

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Left unexplored by model

• Under Fix, since FXL smaller private cost to firms, andcap inflow welfare enhancing, scale effect higher under Fix. Fix may be favored.

• But, if smaller cap inflow under Flex implies lower correlation between real and nominal shocks, ρ, then Flex’s weighted avg of volatilities of GDP and RER could be lower, given possibility of currency mismatch as our structural problem.

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Mismatch more deadly if shocks aren’t random

• Analysis made under assumption: basic random shocks independent of size of mismatch.

• Popular conjecture: The higher the degree of currency mismatch, the higher the variance of money shocks, as currency mismatch may imply close substitutability b/w domestic and foreign monies. (Calvo 1999)

• Thus, slight parameter change (e.g. domestic inflation, rate of return, &c) could induce large changes in domestic money demand.

• Large mismatch favors “Fix”–deals better with nominal shocks—like a vicious cycle.

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Mismatch not a problem in Thailand today

• In Thailand, currency mismatch (and substitution) is a non-issue today.

– Private external debt/GDP quite low (28% v. 58% in 1995, much of it ST).

– Resident non-banks’ FX holdings held domestically and abroad < 5% of M2, very small and comparable to US, Japan, and Australia.

• Superiority of Fix non-existent for Thailand in this dimension

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Key Issue 3: Shocks to the credit channel

• Credit market segmentation implies unhedgedand nontradable sector heavily dependent on bank credit.

• So, changes in monetary aggregate, i.e. credit channel,may impinge on GDP directly.

• Thai economy heavily bank-based• Assuming 1. constant base money multiplier and

2. RER depreciation is expansionary. Then model show output variance smaller under Flex (overall maybe lower as well).

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Major drawback of Fix is credit channel shocks

• Credit channel shocks cannot be dealt with effectively – Impact on bank credit (credit-crunch) or bank liquidity

can come from unanticipated changes in bank deposits (systemic bank runs or rapid disintermediation)

– “Stock” shock; Best stock policy is expansion or contraction of CB credit (See Argentina in 1995 Q1, deposits fell by 18% while pegged to USD, CB lowered reserve requirements to counter contraction in bank credit)

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Fix requires strong banking system

• Fundamental problem of Fix: CB credit expansion results in claims on reserve (losses). Usually, probability of shocks unknown ex ante, else CB could obtain contingent credit lines.

• But if negative liquidity shock accompanied by expectationthat Fix will be abandoned.– Nominal i high b/c of expected devaluation. So even though

CB succeeds and total bank credit constant, i will be high, hurting output, like effect of credit contraction.

• Even if hard Fix, a currency board, may not collapse (though Argentina’s did), but the effect of the large credit channel shocks cannot be completely offset.

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Desirability: Conclusion

• Free Float or Limited Flex seems best for LT growth and inflation performance

• (Short-term) shocks analysis points to some sort of Fix-Flex hybrid

• Fix requires strong banking system and supervision

5. Credibility and Loss of Independent MP

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Credibility is a dynamic problem, matters for every regime

For Fix or Hybrid (at edges of band) • If promise not to devalue lacks credibility, then

gone is the Fix• Developing and maintaining such credibility

increasingly difficult– See experience of failed Fixes or even broad-band

EMS to speculative attacks – Need to lose some or all of control over domestic

money supply (policy)

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Technically, defending unilateral Fix is possible

• Most Fix regimes are unilateral• Sustainability is cause for concern esp. under

incessant world capital market expansion• Technically, if willing to subordinate all other

goals of MP, (even unilateral) Fix is feasible.– Need to buy back part of MB to repel attacks– If coordinated, no attack possible, as fiat currencies

monopolistically supplied by CBs

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Real Problem is competing goals

• Real problem--politically impossible to maintain focus on exchange rate alone when under attack– Time and policy-inconsistency literature

• Flexible regime requires inflation anchor for credibility – the whole IT mantra (transparency, and commitment)

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Policy coordination required for fixing credibly: Forming a currency union

1. Agree to swap currency for another’s at fixed rate, any amount, any time.

• Prevent ER from fluctuating from speculation

2. Agree on total growth of money and distribution of resulting seigniorage

• Guarantee no incentive to overissue their own money

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Can Unilateral Fix be made credible for Thailand? Business cycle evidence

1. EU contemporaneously uncorrelated with Thailand, leading Thai RGDP by 3-5 years & fluctuating 3 times less percentage-wise(Germany is outlier—looks like Japan)

2. US/Canada (NAFTA) counter-cyclical, leading Thailand by 5 years & fluctuating twice less.

3. Japan somewhat pro-cyclical , fluctuating 2-1/2 times less

4. Korea highly pro-cyclical and contemporaneous, fluctuating almost as much as Thailand

Annual data from 1970-2002. Results show no cause/effect

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Fixing implies loss of MP independence very costly for us

• If fix, then with whom?– Thai business cycles not synchronized with any major

currency nation (euro, dollar, yen).

• A single-currency peg may not be credible (too costly)

• Would a rigid basket peg be less costly? Unlikely.• Implies credible Flex approach or try intra-

regional find

6. Support for Adjustable Band, Basket + IT for Thailand

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How much Flex is best for Thailand?

• Large degree of ER flexibility over time• Limiting excessive (speculative) short-term

volatilities and sharp medium-term Real ERswings (orderly adjustments)

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A (Conceptual) Design Problem

• Float NEER within certain well-defined region or band

• Band adjustable over time to neutralize inflation or productivity differentials

• Frequency of band adjustment depends on band’s width and BOT’s view of fundamentals

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Consistent with Inflation Targeting

• Key is BOT determines part of fundamentals (ST i) and basket-band parameters according to inflation target & lets market play principal role with ER in usual times (a judicious balance).

• Treat ER as intermediate target, managed when inconsistent with band

• ER is left as indicator when inside band• This way, band needs to be wide enough

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Basket design: Large weight to USD

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Why relative wide/adjustable band and adjustable parity?

1. CB should not keep defending disequilibrium ER• No model is good enough to determine equilibrium ER

precisely, need wide region to surround our best estimates• Center of band also adjustable for same reason

2. Wide band lets ER help stem tide of excessive ST capital inflows

3. Allows Thailand to reap full benefit of Flex: independent MP policy to deal with business cycles and an asset price bubble burst.

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What parity and should it be announced?

• With aid of market, CB can find acceptable parity through modeling, analysis and trial and error

• No parameters need be made public. ER is not our target and no need to confuse market about MP goal as long as ST interest rate is announced as instrument

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When to adjust band and parity?

• When “too much” pressure builds around band edges or band needs re-centering

• When severe shocks hit

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To conclude the presentation…

• Free Floats & Limited Flex associated with best LT growth and inflation performance, on average.

• For Thailand, Fix-Flex hybrid absorbs shocks better than either extreme

• Fix, even if credible for a while, can be too costly for Thailand—loss of monetary policy independence highly costly

Therefore: Find credible solution in ABB+IT• Support for NEER to float within wide/adjustable band,

all unannounced, (ABB) + Inflation Targeting for Thailand.

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Deviation from trend of Thailand’s and France’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ F R A _ G D P VZ E R O

57

Deviation from trend of Thailand’s and Germany’s real GDP

- 2

- 1

0

1

2

3

4

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ G E R _ G D P VZ E R O

58

Deviation from trend of Thailand’s and Italy’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ I T A _ G D P VZ E R O

59

Deviation from trend of Thailand’s and UK’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ U K _ G D P VZ E R O

60

Deviation from trend of Thailand’s and Holland’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ N E T H _ G D P VZ E R O

61

Deviation from trend of Thailand’s and Canada’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ C A N _ G D P VZ E R O

62

Deviation from trend of Thailand’s and USA’s real GDP

- 3

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ U S A _ G D P VZ E R O

63

Deviation from trend of Thailand’s and Japan’s real GDP

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ J P N _ G D P VZ E R O

64

Deviation from trend of Thailand’s and Korea’s real GDP

- 4

- 3

- 2

- 1

0

1

2

3

1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0

P E R C E N T C Y C L E _ T H A _ G D P VP E R C E N T C Y C L E _ K O R _ G D P VZ E R O