Fear of floating

The term "fear of floating" was first used by Calvo and Reinhart (2002). It refers to the fact that a country, having officially set a floating exchange-rate regime, uses its monetary policy instruments to smooth the exchange rate of its currency, thus avoiding the prob- lems of high variations of it in the foreign-exchange market. According to the authors, fear of floating has been a widespread phenomenon in the international monetary system since the 1970s, especially in emerging countries.

After the collapse of the Bretton Woods fixed exchange-rate regime, nations had to choose between the option of carrying on with exchange-rate fixity or moving towards a flexible exchange-rate regime. Several financial crises in the 1980s and 1990s spread the idea that soft peg regimes - that is, fixed exchange rates with some degree of varia- tion - were destabilizing for emerging countries, so they had to let their currency float in the foreign-exchange market. International Monetary Fund (IMF) statistics seemed to confirm the implementation of this guideline: few countries remained on a fixed exchange-rate regime, whereas the free-floating option became gradually preferred to that of intermediate regimes.

The work of Calvo and Reinhart (2002) shows that observed practices contradict the apparent official extension of floating exchange-rate regimes. Their empirical research concerns 154 exchange-rate arrangements in 39 countries. For each case, they measure the volatility of certain variables - exchange rates, nominal and real interest rates, foreign-exchange reserves, base money, and commodity prices - by computing the probability that each one falls within pre-established narrow bands on a monthly basis.

The authors came to the following conclusion: first, the volatility of the exchange rate is significantly lower in the studied cases than that of the benchmarks - that is, exchange rates between US dollar, Japanese yen, and German Deutsche Mark (now the euro) - even for the self-declared floating exchange-rate regimes. Second, this lower variability of exchange rates can be explained by the need to resort to monetary policy mechanisms - specifically interest-rate changes as well as the use of foreign-exchange reserves - which seem to be more unstable in the analysed floating exchange-rate regimes than in the benchmarks. Therefore, Calvo and Reinhart (2002) confirm the hypothesis that some authors (see Hausmann et al., 2001) had already formulated: most of the de jure floating exchange-rate regimes are rather soft pegs.

The lack of credibility in monetary policies appears as a key aspect behind the efforts of smoothing exchange-rate fluctuations in emerging economies. Monetary instability forces authorities to make exchange-rate stabilization an anchor of monetary policy and to limit the role of the interest-rate instrument regarding this anchor. This can lead, however, to interest-rate volatility and pro-cyclical monetary policies. Nevertheless, it is a way for monetary authorities to avoid particular threats for this group of countries that may be caused by exchange-rate volatility.

The primary threat in this respect is associated with the ability for residents to borrow in foreign markets. In case of depreciation/devaluation of the exchange rate of the domestic currency, capital reversals (capital outflows) or sudden stops (Calvo and Reinhart, 2000a) are more violent in emerging economies than in developed econo- mies, and credit ratings fall more sharply (Calvo and Reinhart, 2000b). Taking into account their weak financial domestic systems, the subsequent tightening in external credit access causes particular contractionary effects in emerging economies. Besides, some emerging markets already have high levels of liability dollarization. Any depre- ciation of the national currency increases the external debt of these countries to the same extent.

Trade openness is another significant factor that explains intolerance to currency floating. Unlike developed countries, exchange-rate uncertainty in emerging markets is considered by several researchers to have harmful effects on trade relations. Some emerging economies are specialized in exporting dollar-denominated goods. Hence, volatility in exchange rates would cause export-level instability. To that uncertainty one should add the negative consequences from depreciation as well as appreciation of the exchange rate. On the one hand, the latter erodes international competitiveness and increases the risk of Dutch-disease-type dynamics. On the other hand, the exchange- rate pass-through is more evident in emerging markets, so that a government willing to maintain a low and stable inflation rate should be interested in securing the stability of the exchange rate.

The debate about the optimal exchange-rate regime and the differences between official and actual regimes has been growing since the end of the twentieth century. In fact, since 1999, the IMF has been developing a de facto regimes listing in contrast to its official-label-based traditional classification (International Monetary Fund, 1999). The fear-of-floating study has provided a major contribution to this discussion, questioning the theoretical advantages of floating exchange-rate regimes, and defending hard pegs - especially dollarization - as a possible "market-friendly" long-term alternative for emerg- ing economies. Since then, several theoretical works (see Fischer, 2001; Eichengreen, 2006) and hard-peg regimes - currency boards, dollarization, and monetary unions - that started in some of both emerging and developed countries in the 1990s have kept this debate open.

See also:

Bretton Woods regime; Capital flight; Central bank credibility; Currency board; Dollarization; Financial crisis; International Monetary Fund; International reserves; Sudden stops.