Drawing on new data and advances in exchange rate regimes’ classification, we find that countries appear to benefit by having increasingly flexible exchange rate systems as they become richer and more financially developed. For developing countries with little exposure to international capital markets, pegs are notable for their durability and relatively low inflation. In contrast, for advanced economies, floats are distinctly more durable and also appear to be associated with higher growth. For emerging markets, our results parallel the Baxter and Stockman classic exchange regime neutrality result, though pegs are the least durable and expose countries to higher risk of crisis.
This paper offers a distinct new twist to the existing academic and policy literature on the durability and performance of alternative exchange rate regimes by drawing on new data and on a new de facto approach to classifying exchange rate regimes (see Reinhart and Rogoff, 2004).1 Although there are many nuances, overall our results suggest that for relatively poor countries with little access to international capital markets, pegged exchange rate regimes work surprisingly well, delivering both relatively low inflation and relatively high exchange rate regime durability. This finding is in contrast to the growing conventional policy wisdom that pegs are universally unstable and crisis prone. However, we also find that as countries become richer and more financially developed, they benefit by moving to more flexible exchange rate systems. Indeed, for advanced economies, flexible exchange rate systems are remarkably durable and (controlling for other factors) yield somewhat higher growth without higher inflation. For emerging markets, the exchange regime does not appear to have a systematic effect on inflation or growth, although—in line with conventional wisdom—pegs are distinctly more vulnerable to banking and exchange rate crises.
Our results also indicate that, in general, exchange rate regimes have been steadily becoming less durable since the mid-1970s, with emerging markets experiencing the most instability. An important exception, however, is advanced economies, for which durability has increased, particularly for flexible rate systems. We also observe a broad trend towards exchange rate regimes with intermediate levels of inflexibility (in contrast to the once fashionable bi-polar hypothesis). Extrapolating out our estimated exchange rate regime transition matrices suggests that pegs, which today account for roughly 40% of all developing country and emerging market exchange rates, will account for only 25% of all regimes in 2020, with intermediate regimes taking up the slack.
In the next section, we discuss alternatives to regime classification and then present evidence on regime durability for all countries and also for developing and emerging market economies. We turn to the evidence on regime performance—evaluating performance in terms of inflation, growth, and crisis outcomes, and differentiating once again between developing, emerging, and advanced economies. It is important to note that whereas one's perspective on regime durability can be quite sensitive to the particular classification system chosen, our results on regime performance are much less sensitive. Rather, the key factor underpinning our results is our three-way grouping of countries into developing, emerging, and advanced. The final section concludes.
Our analysis suggests that the popular notion that pegged exchange rates are problematic everywhere is misplaced. We find, on the one hand, that fixed regimes in poorer developing countries with little access to international capital are associated with lower inflation and higher durability. For emerging markets, on the other hand, our results are more in line with the earlier Baxter-Stockman finding of the absence of any robust relation between economic performance and exchange rate regime. However, emerging markets do appear to experience crises more frequently under pegged regimes. And for advanced economies, we present evidence suggesting that flexible rates may offer significantly greater durability and slightly higher growth, without generating higher inflation. Naturally, exchange rate regimes are a sufficiently broad sweeping and complex topic that much further research is needed to cement these findings and to understand their microeconomic underpinnings. But going forward, we would argue that further studies need to rely on more sophisticated de facto classifications of exchange rate regimes, such as the “Natural classification” we have used. In particular, exchange rate regime performance should be based on classifications that not only look at actual exchange rate behavior but also focus on market-based, rather than official, exchange rates.
