Download developing countries` choice of exchange rate regime should

DEVELOPING COUNTRIES’ CHOICE OF EXCHANGE RATE REGIME SHOULD
DEPEND ON THEIR IMPORT STRUCTURE
Countries that are highly indebted in foreign currencies and which import goods priced
in the domestic currency will not be better insulated against economic crises by having
flexible exchange rates. That is the central finding of research by Pascal Towbin and
Sebastian Weber, which analyses data on a large sample of countries over the period
1975 to 2007.
Their study, presented at the Royal Economic Society’s 2010 annual conference, finds
that the insulation provided by flexible exchange rates vary with a country’s import
structure. If a country predominantly imports raw materials, a fall in output caused by an
external shock is smaller with a flexible exchange rate. If a country imports few raw
materials, the response is smaller under a fixed exchange rate.
These findings imply that as long as countries are not able to raise debt in international
markets in the domestic currency, a move to fixed exchange rates may be preferable.
But the results also imply that an even better policy prescription would be to avoid the
reliance on foreign-denominated debt and move to more flexible exchange rates.
Unfortunately, this is exactly where the dilemma lies: developing countries are often
trapped in a situation in which investors are not willing to provide debt in domestic
currency if exchange rate volatility is high. That forces these countries into the secondbest solution of maintaining a peg to attract more funds.
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Flexible exchange rates do not provide better insulation against external shocks if a
country has high foreign currency debt and mainly imports goods that are typically
priced in local currency.
A popular argument in favour of a flexible exchange rate regime is that it insulates
output better from external shocks than a fixed exchange rate regime. An exchange
rate depreciation in response to a fall in external demand allows the economy to regain
competiveness and helps to stabilise output, as demand shifts away from foreign goods
towards domestic goods.
This study finds that this argument does not a hold when a country has a high level of
foreign currency debt and imports goods that tend to be priced in local currency.
If a firm’s debt is denominated in foreign currency, a depreciation increases leverage.
Higher leverage makes lenders more reluctant to grant credit because of an increased
default risk. A higher risk premium is the consequence. Unfavourable credit conditions
lead to a contraction in investment. With high foreign currency debt this contractionary
effect on investment can dominate the expansionary competitiveness effect.
Drawing on a large sample of countries over the period from 1975 to 2007, this study
compares the reaction of output to a negative external shock (a decrease in the termsof-trade) under a fixed and a flexible exchange rate for different levels of foreign
currency debt (see figure below).
The estimated fall in output for countries with a short-term external debt of around 25%
of GDP and a floating exchange rate regime is about two times larger than the
response for countries with a fixed exchange rate and the same debt level. But in
countries with low foreign currency debt, a flexible exchange rate insulates domestic
output almost perfectly.
If import prices are set in local currency, an exchange rate depreciation cannot affect
the relative price between domestic and import goods. Previous studies have shown
that local currency pricing is less likely for raw materials, where a single price is set on
the world market.
This study finds that the insulation properties of flexible exchange rates vary with the
import structure. If a country imports predominantly raw materials, the fall in output is
smaller with a flexible exchange rate. If a country imports few raw materials, the picture
is reversed and the response is smaller under a fixed exchange rate.
The findings imply that as long as countries are not able to raise debt in international
markets in domestic currency, a move to fixed exchange rate regimes may seem
preferable. But the results also imply that an even better policy prescription would be to
avoid the reliance on foreign denominated debt and move to more flexible exchange
rates.
Unfortunately, this is exactly where the dilemma lies: developing countries are often
trapped in a situation in which investors are not willing to provide debt in domestic
currency if exchange rate volatility is high, which forces these countries into the
second-best solution of maintaining a peg in order to attract more funds.
ENDS
Authors: Pascal Towbin, Sebastian Weber
Contact details: Sebastian Weber (corresponding author),
[email protected], +41 (0) 76 439 4093
Pascal Towbin, [email protected]
Cumulative drop in GDP (in %) in the 2nd year following a 10% fall in the terms of trade
for floating and fixed exchange rate regimes as a function of the external debt level (in
% of GDP)