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Exchange Rate Regime, Trade Openness and Growth: Asian perspective Introduction to the Topic (Relevance & Motivation) -Why

/how ER affects growth, historical evidence in different countries with emphasis on Asian/developing countries -Role of Trade openness and effect on ER, how the growth is affected by any change in trade openness

Background -Exchange rate regime (Meaning & Ways of Calculation) -Effect of ER on GDP {Literature Survey}: The role of trade openness Effect of Financial Development, Trade Openness & Money Supply Data/Methodology/Results/Interpretation Policy Implication & Conclusion

Introduction There has been a history of contention with respect to macroeconomic policy when it comes to the choice of exchange rate regime and the impact of exchange rate volatility on the growth of economy. A country like China‟s relatively inflexible exchange rate system has been the subject of much international scrutiny, whereas across the continent, the fellow BRICS nation South Africa has difficulty in curbing the country‟s high currency volatility. The nature of political economic history has favoured a developed-world focussed view when it comes to assessing the impact of exchange rate regime on growth of the country. It has always been understood that the phenomenon of exchange rate regime and their volatility has an impact on the growth condition in an open economy. As far as the exchange rate regime, the existing theoretical and empirical literature is inconclusive for determination of policy for the developing world. This paper tests whether trade openness matters in choosing how flexible an exchange rate system should be if the objective is to increase the real output per capita. The proportion of country‟s output (gross domestic product) involved in international trade (exports and imports) has been recognized in the literature as good indicator for levels of trade openness. The test is conducted on a set of Asian countries which are classified as the emerging economies. Report is also drawn on the Tiger economies which are considered more open and follow floating exchange rate regime. Significant evidence is found in the case where country being more flexible in its exchange rate, the openness to trade positively impacts the country‟s output. Evolution of Exchange Rate Regimes in Asian economies The de jure exchange rate regimes in Asia span a wide spectrum. Many smaller Asian economies appear to prefer some form of single currency peg. This is true of Hong Kong, China (whose currency board arrangement is pegged to the US dollar); Brunei Darussalam (pegged to the Singapore dollar); Bhutan and Nepal (pegged to the Indian rupee); and Myanmar (pegged to the Special Drawing Rights [SDR]). In contrast, Bangladesh and Sri Lanka in South Asia and the

e. one for each of the four popular exchange rate regime measurement . Brunei Darussalam. in contrast to their work on regime causes. broadly consistent with their official pronouncements. And the authors find no compelling linkage between the exchange rate regime and economic growth. other relevant papers. where the authors experience some empirical success. A number of other Asian countries have adopted a variety of intermediate regimes (currency baskets. Myanmar. and such). the IMF has replaced its compilation of the de jure exchange rate regimes with the behavioural classification of exchange rates. most developing and emerging Asian exchange rate regimes are. Overall. For instance. according to the IMF. Vietnam is classified as having a conventional fixed peg regime compared to its official pronouncement of maintaining a crawling peg and band around the US dollar. While Singapore‟s currency basket regime follows a more strategic orientation. India. I report coefficients when annual real GDP growth is regressed on the exchange rate regime. press reports. crawling bands. There are. which is officially pegged to the SDR. and Thailand are categorized as managed floaters. The flexible exchange rates in the three East Asian countries are accompanied by inflation. Singapore officially manages its currency against a basket of currencies. either completely fixed (soft and hard) or managed. they find that Mundell‟s trilemma works. and the Philippines officially operate flexible exchange rate regimes. Vietnam officially maintains a crawling peg and band around the US dollar. adjustable pegs. however. There are four rows of estimates. For instance. Lao PDR. As noted. Cambodia. There is no discrepancy between the de jure and de facto regimes of Bhutan. keeping the tradeweighted exchange rate within a certain band as a goal in and of itself). The new IMF coding is based on various sources. Hong Kong. Singapore. and Nepal. Pakistan. Similarly. consistent with monetary neutrality.East Asian economies of Indonesia. According to the public pronouncement of the PRC authorities the exchange rate regime is based on a currency basket while the IMF classifies the PRC as a crawling peg. and Sri Lanka have also been characterized as managed floaters (with no predetermined exchange rate path) despite their official declarations of being independent floaters. In Table 2. is defined by the IMF as operating a managed float.targeting frameworks. coupled with the ability to intervene if and when necessary”. including information from IMF staff. China. Bangladesh. with the trade-weighted exchange rate used as an intermediate target to ensure that the inflation target is attained. Thailand also operates an inflation targeting arrangement although it defines itself officially as a managed floater. the Republic of Korea. Exchange Rate Regimes and Economic Growth The consequences of exchange rate regimes. but not nearly as tightly in practice as in theory. both the People‟s Republic of China (PRC) and Malaysia in July 2005 officially shifted to what may be best referred to as a more mechanical version of a currency basket regime (i. with a few exceptions. all of which operate fixed exchange rates to a single currency. Indonesia. The Republic of Korea and the Philippines are characterized as independent floaters. The data span 178 economies from 1974 through 2007. consistent with their official assertions but somewhat odd in view of the fact that both countries have been rapidly building up reserves. according to the Reserve Bank of India. divergences from the official pronouncements. Malaysia. as well as the behaviour of bilateral nominal exchange rates and reserves. the country “monitors and manages the exchange rates with flexibility without a fixed target or a pre-announced target or a band.

8% faster on average than fixers. The choice of exchange rate regime and its impact on economic performance is probably one of the most controversial topics in macro-economic policy.. less flexible exchange rate regimes are associated with slower growth. Mundell (1995) looks at the growth performance for the industrial countries before and after the demise of Bretton Woods. our tests confirm the standard view (and previous empirical work) indicating the presence of a negative link between output volatility and exchange rate flexibility for nonindustrial countries. Finally. for developing countries. the impact of regimes on economic growth has been the subject of surprisingly little work. Among the few papers within this group. In each case. Rolnick and Warren E. show that output growth was higher under fiat standards than under commodity (e. who find a negative significant effect. Contrary to what might have been inferred from the literature. labor force growth. RR define freely falling regimes as those exhibiting extreme macroeconomic distress and annual inflation of over 40%. For industrial countries. However. finding that the former period was associated with faster average growth. if anything.systems. we find that the regime has no significant impact on growth. Then again. adding controls for the savings rate. gold) standards. Symmetrically. Thus. institutions. from which we borrow our baseline specification. The one strong result is eminently plausible: the “Freely Falling” basket cases grouped together by RR grow significantly more slowly than fixers (or any other group for that matter). Both of these regimes are combined together into a single intermediate measure by LYS. however.g. The official IMF classification indicates that countries in narrow crawls grow significantly faster than fixers.6 Also close to our work is the relatively scarce body of literature that directly addresses the relationship between growth and exchange rate regimes. However. The four methodologies disagree on the effects of intermediate exchange rate regimes. the question of whether or not there exists a link between regimes and growth can only be resolved as an empirical matter. Our main reference comes from the numerous empirical papers on the determinants of growth. while the implications regarding inflation and policy credibility have received considerable attention. in the end. I include (but do not report) a comprehensive set of time and country-specific fixed effects. In addition. Ghosh et al. Robust standard errors are included in parentheses. RR find the opposite (a negative but insignificant result). we find that. I treat the fixed exchange rate regime as the default regime. Arthur J. For each of the four regressions. The purpose of this paper is to address this issue by assessing the relationship between exchange rate regimes and output growth for a sample of 183 countries over the post-Bretton Woods period (1974-2000). although the literature. Weber (1997) using long-term historical data. so that the top left estimate indicates that countries which were in narrow crawl exchange rate regimes according to the IMF‟s classification grew some . None of the methodologies finds that floating exchange rate countries grow significantly differently from fixers. seems to offer stronger arguments favoring the idea that fixed exchange rates may lead to higher growth rates. no other growth determinants are included. and so forth is likely to reduce the coefficients further. probably due to the fact that nominal variables are typically considered to be unrelated to longer-term growth performance. where RR find that countries in wide crawls grow significantly more slowly than fixers. (1997) run growth regressions controlling for the de jure exchange rate regime as defined by . the IMF classification delivers a positive but insignificant result.

The result is that (under perfect capital mobility) the decrease in the demand for domestic money leads to an automatic outflow of hard currency and a rise in interest rates. it ultimately fails to address a challenge issued by Mundell himself in his original 1961 paper and many of the underpinnings of the model do not apply especially well to emerging market economies. if a downturn is driven by real factors in an economy with a fixed exchange rate. If a monetary shock causes inflation. our model specification builds on existing results in the growth literature. A de facto classification of ex-change rate regimes that better captures the policies implemented by countries regardless of the regime reported by the country's authorities. shocks that arise from money supply or demand – then a regime of fixed exchange rates looks attractive. In this case. finding no systematic link between the two.the International Monetary Fund (IMF). If an economy faces primarily nominal shocks – that is. the demand for domestic money falls and the central bank is forced to absorb excess money supply in exchange for foreign currency. However. to a large degree owing to their presumed beneficial effects on taming inflation. This standard model of choosing an exchange rate regime offers some useful insights. it will also tend to depreciate a floating exchange rate and thus transmit a nominal shock into a real one. . On the other hand. A shift in the nominal exchange rate offers speedy way of implementing such a change -. ameliorating the impact of these shocks on output and employment. we witnessed a regained popularity of pegs in the 80s and early 90s. the fixed exchange rate provides a mechanism to accommodate a change in the money demand or supply with less output volatility. However. Models of choosing an exchange rate regime typically evaluate such regimes by how effective they are in reducing the variance of domestic output in an economy with sticky prices. it is argued that after the early experiments with floats prompted by the collapse of Bretton Woods. In addition. currency boards) advocated by the bipolar view was further debunked by the Argentine debacle. In this case. On the other hand. focusing on the post-Bretton Woods period and expanding the sample size to include the 1990's.and its close relative the theory of optimal currency areas -which owes much to Mundell (1961) and Poole (1970). if the shocks are real – like a shock to productivity. the economy needs to respond to a change in relative equilibrium prices. like the relative price of tradables with respect to nontradables. and the ephemeral enthusiasm with “hard” pegs (particularly. In this setting. Much of the analysis of choosing an exchange rate regime has taken place using the theory of optimal exchange rate regimes -. the relationship between export prices and import prices shifts due to movements in demand or supply) – then exchange rate flexibility of some sort becomes appealing.1 Following this interpretation. Role of Trade Openness in determination of Exchange Rate Regime – Importance in Growth Much of the recent policy discussion on exchange rate regimes has focused mostly on the trends in regime choice as if this were largely independent from country-specific characteristics. the stream of currency crises that started with the devaluation of the Mexican peso in 1994 have cast doubt on their sustainability. the hard peg contributes to increasing the depth of the downturn.thus. or to the terms of trade (that is.

Yet such temporary fads. degree of openness. floating exchange rate has the benefits of monetary independence. The authors find that. product diversification/ export structure. and the “one-size-fits-all” view of exchange rate arrangements that underlies them. they are not able to borrow in terms of their own currencies long-term or to borrow externally except in terms of foreign currencies. currency crises may be ruled out but banking crises could still be possible and in the absence of monetary discretion. vulnerability to real/nominal shocks. On the contrary. devaluation can. in recent years there has been a growing consensus in favor of flexible arrangements. In the face of a currency crisis. devaluations may have no effect on the real economy in the face of widespread indexation or a history of high inflation. for good or bad. is the so-called problem of „original sin‟ (Eichengreen and Hausmann. Hong Kong) and others don‟t (Canada. Literature Survey Some economies fix their exchange rate (Denmark. financial and political variables. it cannot be automatically contained (Chang and Velasco. 1999) which states that because many emerging countries are financially under-developed and have a history of high inflation and fiscal laxity. There may be very high passthrough from the exchange rate to the price level or in the case of “original sin”. thereby exposing them to the problems of currency and maturity mismatches. For the emerging market economies (EMEs). divergence of domestic inflation from trading partners. This endogeneity of exchange rate regimes has not gone unnoticed in the economic literature. such as the size of the economy. A number of countries have also changed their policy and switched to a different regime (Thailand in July 1997. devaluing may . New Zealand). the choice of exchange regime becomes even more critical because of a few additional constraints faced by them. Third. in the case of hard pegs. seem at odds with both the casual evidence and the conventional wisdom that indicate that the regime choice is itself endogenous to the local and global economic contexts. reducing unpredictable volatility and transactions costs. the way countries choose their exchange rate regime in response to these basic determinants has not changed substantially over the last two decades. insulation from real shocks and a less disruptive adjustment mechanism in the face of nominal rigidities. therefore. Argentina in Jan 2002). for emerging economies that float. labour mobility. and to what extent. 2001). capital mobility. widespread bankruptcies and debt default. providing transparency. over the last forty years a large body of analytical work has provided key insights on the potential determinants of the regime choice. the alternative approaches identified by the literature help explain the choice of exchange rate regimes. While fixed exchange rate is seen to have the advantage of a nominal anchor for “importing” credibility. the key normative insights provided by the academic literature have influenced actual exchange rate policy beyond the occasional twists and turns that characterized the exchange rate debate.As a result. once all contending hypotheses are considered jointly. and how the drivers underlying the choice of regime have changed over time. fiscal policy flexibility. credibility of policymakers and degree of economic/financial development. Moreover. Second. lead to serious balance sheet problems. First. the choice of exchange rate regimes can indeed be traced back to a few simple determinants that include a combination of trade. suggesting that. Another paper tests whether. The choice of exchange rate regime is not straightforward and is in fact contingent on a host of factors.

Malaysia. many countries that state they peg have a lot of inflation and capital controls so that their currencies actually trade at deep discounts on black markets. For the transition economies esp. LYS combine data on exchange rates and international reserves using cluster analysis. Conversely. The different nature of financial development in different countries – developing and developed. as discussed above. These countries have been studied exclusively because of their importance as more open economies and their significance due to the East Asian crisis during the late 1990s. that way they can account for exchange market intervention as well as exchange rate movements. the ones in South-East part of the continent which classify as small open economies need some discussion as to what their exchange rate regime policy is to be shaped. Thailand. For the developed countries. His conjecture is that for open economies. Each is based on a different technique. hereafter “LYS”). Exchange Rate Regimes A number of exchange rate regimes have been developed e. The exchange rate regime puzzle has been debated upon for quite some time now. Singapore and Philippines. Thailand. Much of the research. these often diverge from official ones when there are parallel or dual markets because of capital controls. there has been a vast literature on how the fixed/floating . In fact. The historical evidence doesn‟t suggest any conclusive evidence on the parameters which really affect the exchange rate regime to be followed in a country. In the above context. The effect of financial development on exchange rate regime has always been at the centre of research. is aimed at developed countries and serves them well.actually be contractionary.g. the case of emerging Asian economies needs more illustration. this group contains the Tiger economies of Asia viz. Shambaugh classifies a country as pegged if its official exchange rate remains within a small band for a sufficiently long period of time. “RR”) and one by Shambaugh (2004). Indonesia. The sample for analysis includes 18 countries belonging to the loose definition of emerging Asian economies. Many countries that state they float actually intervene to smooth the exchange rate a lot (a phenomenon known as “fear of floating”). Reinhart and Rogoff (2004. the exchange rate volatility and openness to trade are negatively correlated. does play a role in deciding whether the country adopts a floating or a fixed exchange rate regime. by Levy-Yeyati and Sturzenegger (2003. All the methods classify nominal exchange rate regimes. RR rely on the movements of market‐determined exchange rates. Impact of Trade openness Hau (2002) discusses the impact of trade openness on trade openness. In Aghion et al (2006) the authors construct an equation and test whether the financial development of a country has any role to play in the determination of exchange rate regime of a country. Singapore. A number of factors seem to be at work which contributes to the endogeneity of the exchange rate regime.

Jonathan D. pp. Journal of Monetary Economics 56 (2009). Working Paper 09-83 Departamento de Economía. Floating. Eduardo Levy-Yeyati and Federico Sturzenegger. Andrew K. Philippe Bacchetta. All these nations are experiencing similar growth stages and pattern of development which has at its base rapid industrialization and upgradation of infrastructure.exchange rate regime has been affecting productivity growth. and Flaky. Methodology and Data Sources The analysis has been done on a Panel data for 18 countries belonging to Asia with sub-results for Tiger economies and the rest of the countries. 2011. Philippe Aghion. Universidad Carlos III de Madrid. 1996. Federico Sturzenegger. UC Berkeley. Atish R. The Evolution and Impact of Asian Exchange Rate Regimes. Rose. November 09 . Eduardo Levy-Yeyati. No. and Iliana Reggio. 4 (Sep. June 1. But. Economic Series (47). Vol. Policy Implications Conclusions Bibliography  Ramkishen S. International Monetary Fund  Exchange rate volatility and productivity growth: The role of financial development. Romain Ranciere. Pg 494–513  On the Endogeneity of Exchange Rate Regimes. Kenneth Rogoff. AnnMarie Gulde. the research is still inconclusive and not much evolved. NBER and CEPR  To Float or to Fix: Evidence on the Impact of Exchange Rate Regimes on Growth. 1173-1193  Does the Exchange Rate Regime Matter for Inflation and Growth?. 208 | July 2010. Ghosh. 93.. 2003). ADB Economics Working Paper Series  Exchange Rate Regimes in the Modern Era: Fixed. for the developing counties. Ostry. The American Economic Review. Holger Wolf. Rajan. No.