III.GeneralCriticismsofExchangeRate-PeggingThere are several criticisms in the literature that are leveled against exchange-rate pegging inboth developed and emerging market countries which we will examine first.4These include the lossof an independent monetary policy,the transmission of shocks from the anchor country,thelikelihood of speculative attacks and the potential for weakeningtheaccountability of policymakersto pursue anti-inflationary policies.However, there is an additional criticism of exchange-rate pegsin emergingmarketcountries that does not apply to developed countries:the potential in emergingmarket countries for an exchange-rate peg to increase financial fragility and the likelihood of afinancial crisis.It is this last criticism that we will focus on in the next section which suggests thatan exchange-rate peg is a very dangerous strategy for controlling inflation in emerging marketcountries.LossofIndependentMonetaryPolicyOne prominent criticism of adopting an exchange-rate peg to control inflation is that it results in theloss of an independent monetary policyforthe pegging country.Wehave already seen that withopen capital markets, interest rates in the country pegging its exchange rate are closely linked tothose of the anchor country it is tied to, and its money creation is constrained by money growth inthe anchor country. A country that has pegged its currency to that of the anchor country thereforeloses the ability to use monetary policy to respond to domestic shocks that are independent ofthose hitting the anchor country.For example, if there is a decline in domestic demand specific tothe pegging country, say because ofa decline in the domestic government's spending or a decline inthedemand for exports specific to that country,monetary policy cannot respond by loweringinterest rates because these rates are tied to those of the anchor country.The result is that bothoutput and even inflation mayfall below desirable levels,with themonetary authoritiespowerless4An excellent additional discussion of these criticisms is contained inObstfeld and Rogoff (1995)
III. General Criticisms of Exchange Rate-Pegging There are several criticisms in the literature that are leveled against exchange-rate pegging in both developed and emerging market countries which we will examine first.4 These include the loss of an independent monetary policy, the transmission of shocks from the anchor country, the likelihood of speculative attacks and the potential for weakening the accountability of policymakers to pursue anti-inflationary policies. However, there is an additional criticism of exchange-rate pegs in emerging market countries that does not apply to developed countries: the potential in emerging market countries for an exchange-rate peg to increase financial fragility and the likelihood of a financial crisis. It is this last criticism that we will focus on in the next section which suggests that an exchange-rate peg is a very dangerous strategy for controlling inflation in emerging market countries. Loss of Independent Monetary Policy One prominent criticism of adopting an exchange-rate peg to control inflation is that it results in the loss of an independent monetary policy for the pegging country. We have already seen that with open capital markets, interest rates in the country pegging its exchange rate are closely linked to those of the anchor country it is tied to, and its money creation is constrained by money growth in the anchor country. A country that has pegged its currency to that of the anchor country therefore loses the ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. For example, if there is a decline in domestic demand specific to the pegging country, say because of a decline in the domestic government's spending or a decline in the demand for exports specific to that country, monetary policy cannot respond by lowering interest rates because these rates are tied to those of the anchor country. The result is that both output and even inflation may fall below desirable levels, with the monetary authorities powerless 4An excellent additional discussion of these criticisms is contained in Obstfeld and Rogoff (1995)
to stopthesemovements.This criticism of exchange-rate pegging may be less relevant for emerging market countriesthan it is for developed countries. Because many emerging market countries have not developed thepolitical or monetary institutions which result in the ability to use discretionary monetary policysuccessfully, they may have little to gain from an independent monetary policy but a lot to loseThus,they would be better off by,in effect, adopting the monetary policy of a country like theUnited States through exchange-rate pegging than in pursuing their own independent policy.Transmissionof ShocksfromtheAnchor CountryAnother criticism of exchange-rate pegging is that shocks in the anchor country will be moreeasily transmitted to the pegging country,with possible negative consequences.For example, in1994concernsaboutinflationarypressure in theUnited States ledtheFederal Reserveto implementa series of increases in the federal funds rate.Although this policy was appropriate and highlysuccessful forthe United States, the consequences for Mexico, who had adopted a peg to the dollaras part of its stabilization strategy, were severe.The doubling in short-term U.S.rates from aroundthreeto sixpercentwas transmitted immediatelyto Mexicowhofound its short-termratesdoublingfrom around ten to twenty percent.This rise in rates was damaging to the balance sheets of bothhouseholds, nonfinancial business and the banks, and was a factor in provoking the foreign exchangeand financial crisis in Mexico which began in December 1994.(See Mishkin, 1996.)SpeculativeAttacksA further criticism of exchange-rate pegging is that, as emphasized in Obstfeld and Rogoff(1995), it leaves countries open to speculative attacks on their currencies. As we have seen inEurope in 1992, Mexico in 1994 and more recently in southeast Asia, it is certainly feasible forgovernments to maintain their exchange ratepegby raising interest rates sharply,but theydo notalways have the will to do so. Defending the exchange rate by raising interest rates can be verycostly because it involves having to tolerate the resulting rise in unemployment and damage to the
to stop these movements. This criticism of exchange-rate pegging may be less relevant for emerging market countries than it is for developed countries. Because many emerging market countries have not developed the political or monetary institutions which result in the ability to use discretionary monetary policy successfully, they may have little to gain from an independent monetary policy but a lot to lose. Thus, they would be better off by, in effect, adopting the monetary policy of a country like the United States through exchange-rate pegging than in pursuing their own independent policy. Transmission of Shocks from the Anchor Country Another criticism of exchange-rate pegging is that shocks in the anchor country will be more easily transmitted to the pegging country, with possible negative consequences. For example, in 1994 concerns about inflationary pressure in the United States led the Federal Reserve to implement a series of increases in the federal funds rate. Although this policy was appropriate and highly successful for the United States, the consequences for Mexico, who had adopted a peg to the dollar as part of its stabilization strategy, were severe. The doubling in short-term U.S. rates from around three to six percent was transmitted immediately to Mexico who found its short-term rates doubling from around ten to twenty percent. This rise in rates was damaging to the balance sheets of both households, nonfinancial business and the banks, and was a factor in provoking the foreign exchange and financial crisis in Mexico which began in December 1994. (See Mishkin, 1996.) Speculative Attacks A further criticism of exchange-rate pegging is that, as emphasized in Obstfeld and Rogoff (1995), it leaves countries open to speculative attacks on their currencies. As we have seen in Europe in 1992, Mexico in 1994 and more recently in southeast Asia, it is certainly feasible for governments to maintain their exchange rate peg by raising interest rates sharply, but they do not always have the will to do so. Defending the exchange rate by raising interest rates can be very costly because it involves having to tolerate the resulting rise in unemployment and damage to the
balance sheets of financial institutions from these high rates.Once speculators begin to questionwhether the government's commitment to the exchange-rate peg is strong because of the now highcosts to maintain it, they are in effect presented with a one-way bet, where the only way for thevalue of the currency togo is down.Defenseofthe currency nowrequires massive intervention andevenhigherdomestic interestrates.With all but the strongest commitment to the exchange-rate peg, a government will be forcedto devalue its currency. The attempted defense of the currency will not come cheaply because ofthe losses sustained as a result of the previous exchange-market intervention,For example, in thecaseoftheSeptember1992crisis,theBritish,French,Italian,SpanishandSwedishcentralbankshad intervened to the tune of an estimated s10o billion. Reports in the press estimated that thesecentral banks lost $4 to $6 billion as a result of their exchange-rate intervention in the crisis, anamount that was in effect paid by taxpayers in these countries. Although the losses suffered bycentral banks in emerging market countries after an unsuccessful defense of the currency areharderto estimate, they are likelyto havebeen very substantial.WeakenedAccountabilityIn the United States, the long-term bond market provides signals that make overlyexpansionary monetarypolicyless likely.If theFederal Reserve pursues overly expansionarymonetary policy or politicians put a lot of pressure on the Fed to do so, the bond market is likely toundergo an inflation scare of the type described in Goodfriend (1993) in which long-tem bondprices sink dramatically and long-term rates spike upwards.Concerns about inflation scares in thelong-bond market help keep the Fed from pursuing expansionary policy actions to meet short-runemployment objectives, which ameliorates the time-inconsistency problem. Thus, the signals fromthe long-bond market make the Federal Reserve more accountable for keeping inflation undercontrol.Similarly,politiciansaremorereluctantto criticize Federal Reserve anti-inflation actionsbecause of their fears of what the long-bond market's reaction will be. The long-bond market thusnot only produces signals which help diminish the time-inconsistency problem by making thecentral bank more accountable, but also by reducing political pressure for overly expansionary
balance sheets of financial institutions from these high rates. Once speculators begin to question whether the government's commitment to the exchange-rate peg is strong because of the now high costs to maintain it, they are in effect presented with a one-way bet, where the only way for the value of the currency to go is down. Defense of the currency now requires massive intervention and even higher domestic interest rates. With all but the strongest commitment to the exchange-rate peg, a government will be forced to devalue its currency. The attempted defense of the currency will not come cheaply because of the losses sustained as a result of the previous exchange-market intervention. For example, in the case of the September 1992 crisis, the British, French, Italian, Spanish and Swedish central banks had intervened to the tune of an estimated $100 billion. Reports in the press estimated that these central banks lost $4 to $6 billion as a result of their exchange-rate intervention in the crisis, an amount that was in effect paid by taxpayers in these countries. Although the losses suffered by central banks in emerging market countries after an unsuccessful defense of the currency are harder to estimate, they are likely to have been very substantial. Weakened Accountability In the United States, the long-term bond market provides signals that make overly expansionary monetary policy less likely. If the Federal Reserve pursues overly expansionary monetary policy or politicians put a lot of pressure on the Fed to do so, the bond market is likely to undergo an inflation scare of the type described in Goodfriend (1993) in which long-term bond prices sink dramatically and long-term rates spike upwards. Concerns about inflation scares in the long-bond market help keep the Fed from pursuing expansionary policy actions to meet short-run employment objectives, which ameliorates the time-inconsistency problem. Thus, the signals from the long-bond market make the Federal Reserve more accountable for keeping inflation under control. Similarly, politicians are more reluctant to criticize Federal Reserve anti-inflation actions because of their fears of what the long-bond market's reaction will be. The long-bond market thus not only produces signals which help diminish the time-inconsistency problem by making the central bank more accountable, but also by reducing political pressure for overly expansionary
monetarypolicyto increase employment in the short-termIn many countries, particularly emerging market countries, the long-term bond market isessentiallynonexistent.Inthesecountries,however,theforeignexchangemarketcanplayasimilarrole to the long-bond market in constraining policy from being too expansionary.In the absence ofan exchange rate peg, daily fluctuations in the exchange rate provide information on the stance ofmonetary policy, thus making monetary policymakers more accountable. A depreciation of theexchange rate can provide an early warning signal to the public and policymakers that monetarypolicy is overly expansionary.Furthermore, just as the fear of a visible inflation scare in the bondmarket that causes bond prices to decline sharply constrains politicians from encouraging overlyexpansionary monetary policy, fear of immediate exchange rate depreciations can constrainpoliticians in countries without long-term bond markets from supporting overly expansionarypolicies.An important disadvantage of an exchange rate peg is that it removes the signal that theforeign exchangemarket provides about the stanceof monetary policy on a daily basis.Underapegged exchange-rate regime, central banks often pursue overly expansionary policies that are notdiscovered until too late, when a successful speculative attack has gotten underway.The problemof lack of accountability ofthe central bank under a pegged exchange-rate regime is particularly acutein emerging market countries where the balance sheets of the central banks are not as transparent asin developed countries, thus making it harder to ascertain the central bank's policy actions.Although, an exchange-rate peg appears to provide rules for central bank behavior that eliminates thetime-inconsistency problem, it can actually make the time-inconsistency problem more severebecause it may actually make central bank actions less transparent and less accountableIV.WhyExchangeRatePegging is SoDangerousfor Emerging Market CountriesThe potential dangers from an exchange-rate peg described above apply to both developed
monetary policy to increase employment in the short-term. In many countries, particularly emerging market countries, the long-term bond market is essentially nonexistent. In these countries, however, the foreign exchange market can play a similar role to the long-bond market in constraining policy from being too expansionary. In the absence of an exchange rate peg, daily fluctuations in the exchange rate provide information on the stance of monetary policy, thus making monetary policymakers more accountable. A depreciation of the exchange rate can provide an early warning signal to the public and policymakers that monetary policy is overly expansionary. Furthermore, just as the fear of a visible inflation scare in the bond market that causes bond prices to decline sharply constrains politicians from encouraging overly expansionary monetary policy, fear of immediate exchange rate depreciations can constrain politicians in countries without long-term bond markets from supporting overly expansionary policies. An important disadvantage of an exchange rate peg is that it removes the signal that the foreign exchange market provides about the stance of monetary policy on a daily basis. Under a pegged exchange-rate regime, central banks often pursue overly expansionary policies that are not discovered until too late, when a successful speculative attack has gotten underway. The problem of lack of accountability of the central bank under a pegged exchange-rate regime is particularly acute in emerging market countries where the balance sheets of the central banks are not as transparent as in developed countries, thus making it harder to ascertain the central bank's policy actions. Although, an exchange-rate peg appears to provide rules for central bank behavior that eliminates the time-inconsistency problem, it can actually make the time-inconsistency problem more severe because it may actually make central bank actions less transparent and less accountable. IV. Why Exchange Rate Pegging is So Dangerous for Emerging Market Countries The potential dangers from an exchange-rate peg described above apply to both developed