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 Chinas 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 countrys 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 countrys 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 countrys 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

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

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

the International Monetary Fund (IMF), finding no systematic link between the two. 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. In addition, our model specification builds on existing results in the growth literature, focusing on the post-Bretton Woods period and expanding the sample size to include the 1990's. Much of the analysis of choosing an exchange rate regime has taken place using the theory of optimal exchange rate regimes -- and its close relative the theory of optimal currency areas -which owes much to Mundell (1961) and Poole (1970). 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. If an economy faces primarily nominal shocks that is, shocks that arise from money supply or demand then a regime of fixed exchange rates looks attractive. If a monetary shock causes inflation, it will also tend to depreciate a floating exchange rate and thus transmit a nominal shock into a real one. In this setting, the fixed exchange rate provides a mechanism to accommodate a change in the money demand or supply with less output volatility. On the other hand, if the shocks are real like a shock to productivity, or to the terms of trade (that is, 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. In this case, the economy needs to respond to a change in relative equilibrium prices, like the relative price of tradables with respect to nontradables. A shift in the nominal exchange rate offers speedy way of implementing such a change -- thus, ameliorating the impact of these shocks on output and employment. On the other hand, if a downturn is driven by real factors in an economy with a fixed exchange rate, the demand for domestic money falls and the central bank is forced to absorb excess money supply in exchange for foreign currency. 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. In this case, the hard peg contributes to increasing the depth of the downturn. This standard model of choosing an exchange rate regime offers some useful insights. However, 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. 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.1 Following this interpretation, it is argued that after the early experiments with floats prompted by the collapse of Bretton Woods, we witnessed a regained popularity of pegs in the 80s and early 90s, to a large degree owing to their presumed beneficial effects on taming inflation. However, the stream of currency crises that started with the devaluation of the Mexican peso in 1994 have cast doubt on their sustainability, and the ephemeral enthusiasm with hard pegs (particularly, currency boards) advocated by the bipolar view was further debunked by the Argentine debacle.

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

actually be contractionary. Exchange Rate Regimes A number of exchange rate regimes have been developed e.g. by Levy-Yeyati and Sturzenegger (2003, hereafter LYS), Reinhart and Rogoff (2004, RR) and one by Shambaugh (2004). Each is based on a different technique. LYS combine data on exchange rates and international reserves using cluster analysis; that way they can account for exchange market intervention as well as exchange rate movements. RR rely on the movements of marketdetermined exchange rates; these often diverge from official ones when there are parallel or dual markets because of capital controls. Shambaugh classifies a country as pegged if its official exchange rate remains within a small band for a sufficiently long period of time. All the methods classify nominal exchange rate regimes. Many countries that state they float actually intervene to smooth the exchange rate a lot (a phenomenon known as fear of floating). Conversely, 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. A number of factors seem to be at work which contributes to the endogeneity of the exchange rate regime. 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. The different nature of financial development in different countries developing and developed, does play a role in deciding whether the country adopts a floating or a fixed exchange rate regime. In the above context, the case of emerging Asian economies needs more illustration. Much of the research, as discussed above, is aimed at developed countries and serves them well. For the transition economies esp. 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. The sample for analysis includes 18 countries belonging to the loose definition of emerging Asian economies. In fact, this group contains the Tiger economies of Asia viz. Singapore, Thailand, Malaysia, Indonesia, Thailand, Singapore and Philippines. 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. Impact of Trade openness Hau (2002) discusses the impact of trade openness on trade openness. His conjecture is that for open economies, the exchange rate volatility and openness to trade are negatively correlated.

The exchange rate regime puzzle has been debated upon for quite some time now. The historical evidence doesnt suggest any conclusive evidence on the parameters which really affect the exchange rate regime to be followed in a country. The effect of financial development on exchange rate regime has always been at the centre of research. For the developed countries, there has been a vast literature on how the fixed/floating

exchange rate regime has been affecting productivity growth. But, for the developing counties, the research is still inconclusive and not much evolved. 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. All these nations are experiencing similar growth stages and pattern of development which has at its base rapid industrialization and upgradation of infrastructure. Policy Implications Conclusions Bibliography Ramkishen S. Rajan, The Evolution and Impact of Asian Exchange Rate Regimes, No. 208 | July 2010, ADB Economics Working Paper Series Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky, Andrew K. Rose, June 1, 2011, UC Berkeley, NBER and CEPR To Float or to Fix: Evidence on the Impact of Exchange Rate Regimes on Growth, Eduardo Levy-Yeyati and Federico Sturzenegger, The American Economic Review, Vol. 93, No. 4 (Sep., 2003), pp. 1173-1193 Does the Exchange Rate Regime Matter for Inflation and Growth?, Atish R. Ghosh, AnnMarie Gulde, Jonathan D. Ostry, Holger Wolf, 1996, International Monetary Fund Exchange rate volatility and productivity growth: The role of financial development, Philippe Aghion, Philippe Bacchetta, Romain Ranciere, Kenneth Rogoff, Journal of Monetary Economics 56 (2009), Pg 494513 On the Endogeneity of Exchange Rate Regimes, Eduardo Levy-Yeyati, Federico Sturzenegger, and Iliana Reggio, Working Paper 09-83 Departamento de Economa, Economic Series (47), Universidad Carlos III de Madrid, November 09