January 03, 2008
Do We Really Know that a Flexible Exchange Rate Regime Facilitates Current Account Adjustment?
In an post in VoxEU, Shang-Jin Wei alluded to work we have undertaken examining whether de facto exchange rate regimes have an impact on current account reversion.
What do we do in this paper? We examine whether the rate at which current account balances revert to mean. We examine the sensitivity of the results to exchange rate regimes, to country groups, and to estimation methods. In addition, we examine if similar patterns hold for real exchange rates.
What do we find? There is no robust evidence that more flexible regimes exhibit faster current account reversion. While current account balance reversion is typically fastest for currencies on a pure or near-pure float, reversion is not necessarily slower as the regime becomes more inflexible. Rather, pure float or pure fix regimes typically exhibit fastest reversion.
More specifically, in a standard pooled regression, no statistically significant effect is detected. In a time fixed effects model, fixed exchange rate regimes exhibit greater persistence, although more flexibility does not necessarily lead to faster reversion.
To be more specific, how do we obtain these results? We estimate autoregressions, interacting dummy variables for de facto exchange rate regimes. We assume AR(1) time series processes, which appear reasonable for annual data (see Chinn and Prasad [pdf]). We also control for trade openness (the sum of exports and imports, normalized by GDP) and financial openness (the Chinn-Ito index).
We test our models on 170 countries worth of current account, trade opennesss, GDP data from World Development Indicators, with the real effective exchange rates from the IMF's International Financial Statistics. The exchange rate regime data are from Levy-Yeyati/Sturzenegger  (cross-checked with data from Reinhart/Rogoff ).
What are the statistical results? The way to interpret the results is to associate higher AR(1) coefficients with greater persistence. Hence, the lower the AR(1) coefficient, the faster current account balances revert to mean. The priors, associated with conventional wisdom and advice to move to more flexible exchange rates, would suggest monotonically higher AR(1) coefficients as one moves to more rigid regimes. Figure 1 shows the AR(1) coefficients for the non-industrial country sample (blue bars) and non-industrial ex oil country sample (red bars).
Figure 1: AR(1) coefficients for current account to GDP ratios estimated in pooled OLS regressions on non-industrial country sample (blue bars) and non-industrial ex oil sample (red bars), stratified by Levy-Yeyati and Sturzenegger classifications. Source: Chinn and Wei (2008).
We check to see if the results are robust against several modifications. First, size. Larger countries exhibit slower current account reversion, when compared to smaller (as measured by PPP GDP). However, if there is any effect from fixed exchange rates, it is that fixed rate countries exhibit faster reversion. Interestingly, when we stratify by G-7 versus non-G-7 countries, we find a similar pattern for non-G-7 countries: faster reversion under fixed rates.
Astute readers will observe that we take the de facto exchange rate regime as exogenous. However, one could plausibly argue that the selection of exchange rate regime is a function of current account reversion, or alternatively, the exchange rate regime and the rate of reversion are both functions of a common factor. In order to account for this possibility, we use a two-stage instrumental variables procedure to deal with potential endogeneity.
Specifically, what we do is to estimate a probit for exchange rate regime, using as determinants the variables suggested by Levy-Yeyati and Sturzenegger (2003) [pdf]: economic size, land area, island dummy, inital foreign exchange reserves, as well as a regional factor (in LYS, it's the average exchange rate regime for the region; we just use regional dummies).
In the end, we find that instrumenting does not change the results. Exchange rate regimes do not affect the pace of reversion in a statistically significant fashion.
We also examine real (trade-weighted) exchange rate persistence. Here we do find more fixed regimes exhibit more rate persistence in the fixed effects specification.
Figure 2: AR(1) coefficients for log real effective exchange rates estimated in fixed effects regressions on non-industrial country sample (blue bars) and non-industrial ex oil sample (red bars), stratified by Levy-Yeyati and Sturzenegger classifications. Source: Chinn and Wei (2008).
The details of the exchange rate regressions, I leave for a future post.
Now, let me depart from the empirical results in the paper to discuss how these findings inform the ongoing debate about Chinese adjustment. As I've discussed in previous posts , a more rapid pace of real, effective, exchange rate appreciation would be beneficial to China (in terms of inflation stabilization and external balance adjustment), as well as to the world economy . But that is separate from the issue of whether greater exchange rate flexibility induces faster current account reversion.
(I'll be presenting this paper at the ASSA meetings, subbing for Frankel/Parsley/Wei in the panel "Exchange Rates and Trade Prices in Emerging Markets".)
Posted by Menzie Chinn at January 3, 2008 07:50 PMdigg this | reddit
Interesting work Menzie. Here are a couple of thoughts.
Interest rate differentials play an important role in the adjustment process. Looking from the financial side, high expected rates of return lead to current account deficits. This will, on average, be picked up by your country specific current account dummies but will not help if countries have relatively high rates at some times and relatively low rates at other times. Think Australia, New Zealand and Canada transitioning from unreliable to reliable monetary policy. I did not check if your pooled regressions contain country specific fixed effects.
Of course, interest rate differentials are endogenous to the exchange rate regime. While this makes the analysis more complicated, it is certainly worthy of investigation.
There is some ambiguity about whether it is better to normalize the current account by GDP or a tradeable measure such as exports. The IMF often talks about export normalizations in the sense of ability to pay. Your openness control helps here.
Posted by: jfund at January 4, 2008 06:03 AM
What do you think about turkey current account deficit from 5 year ? there is flexible exchange regime but current account deficit continue (has been growing )
Posted by: Engin Yılmaz at January 4, 2008 11:51 AM
a couple of questions:
a) How do you determine a country's exchange rate regime. The imf classification is as you know notoriously unreliable -- china supposedly floated well before 2005 ...
b) did you test to see if countries with surpluses and pegs adjust more slowly than countries with deficits and pegs? my guess is that the limits on how many reserves you can sell create a rather hard constraint in one direction, but not the other.
Posted by: bsetser at January 4, 2008 02:06 PM
who is this bsetser guy?
as far as my feeble mind can remember from grad school, isnt it all just really which of the three anchors you pick?
fx, i, or inflation?
gotta pick one and the rest follows, of course dependent on your reserves and ability to defend.
bsetser: nice to run into you again. i was a fan of you and your predecessor well prior to RGE. i remember the site back at NYU as being the end all be all in development econ. congrats on the progress.
Posted by: dc1000 at January 4, 2008 09:22 PM
jfund: Since the current account has to equal the total capital account (aka the financial account, including the transactions on official reserves) one might expect a determinant of the private capital account to enter. But the intervening gap is official reserves transactions (which would be zero under pure float). Thus, one could make the argument for interest rates, although from a different perspective than the one we use -- will try.
Engin Yilmaz: Afraid I don't have an opinion, not having followed Turkey over the past 5 years.
bsetser: Good questions. (1) I'm using de facto measures, not de jure. (2) No, we didn't test for this particular asymmetry. Good idea.
dc1000: Yes, I think you're referring to the trilemma (capital mobility, fixed rates, and monetary autonomy). If we had perfect measures of the relevant variables, we could test this proposition directly, which applies directly to levels (not persistence), but we don't. Hence, this paper.
Posted by: Menzie Chinn at January 5, 2008 05:16 AM
trilemma, hopefully this word supplants the (over-)usage of the, now, threadbare: "perfect storm".
Prof Chinn,(and, certainly, Prof Hamilton)
Good to see you in the New Year, may it find you, and yours, Happy & Healthy.
Posted by: Mark E Hoffer at January 5, 2008 02:20 PM
With all due respect, these types of analyses don't mean alot. Running a current account deficit or surplus is not only dependent on your country's currency regime, but also on your trading partners'. The fact that the US has a floating exchange rate has less effect on its c/a deficit than the fact that many of its trading partners have dirty floats and pegged exchange rates AND also engage in official dollar reserve building.
You can't have a current account deficit without another country willing to run a capital account deficit with you. When a dollar goes abroad by buying an import, it can either make its way back to the US to buy US goods or to invest in US capital. It doesn't matter what the other country's exchange rate regime is. If the money is used to buy US capital, then it encourages the US to run a trade deficit and a capital account surplus.
I don't understand why seemingly everyone ignores this simple fact. The US can not run a current account deficit without also running a capital account surplus. The US can run a capital account surplus because (i) private investors see more opportunity to productively invest in the US than their home country, like what happened in the late 1800s and somewhat in the early 1980s and late 1990s; (ii) private investors see unnaturally high real interest rates that have been distorted by monetary and/or fiscal policy, which happened in the early 1980s and late 1990s; and (iii) countries engage in insurance-related or mercantilist official reserve-building, which is going on now, particularly with Asian and Oil producing countries. The scenarios in (i) and (ii) will unwind on their own, either via capital flow reversion or inflation. The risk for countries that engage in (iii) is that they face mounting domestic inflation pressure and speculative bubbles while reserves are building and the risk of deflation when the process unwinds.
The financial and monetary roller coaster will not stop until a proper international currency system is put in place that provides stability, prevents mercantilist manipulation, and is fair to both developed and developing nations.
Posted by: Tyler at January 9, 2008 01:32 PM