Fear of floating
Fear of floating is the hesitancy of a country to follow a floating exchange rate regime, rather than a fixed exchange rate. This is more relevant in emerging economies, especially when they suffered from financial crisis in the last two decades. In foreign exchange markets of the emerging market economies, there is evidence showing that countries who claim they are floating their currency, are actually reluctant to let the nominal exchange rate fluctuate in response to macroeconomic shocks. In the literature, this is first convincingly documented by Calvo and Reinhart with "fear of floating" as the title of one of their papers in 2000. Since then, this widespread phenomenon of reluctance to adjust exchange rates in emerging markets is usually called "fear of floating". Most of the studies on "fear of floating" are closely related to literature on costs and benefits of different exchange rate regimes.
Floating vs. Fixed exchange rate
To understand the benefits and costs of floating a currency, we need to make a simple comparison between a floating exchange rate and a fixed exchange rate. A floating exchange rate refers to the situation when the currency's value is allowed to fluctuate according to the foreign exchange market. The value of this currency is determined by the supply and demand shocks in the market of the currency. Most of the countries adopting the free, floating exchange rate regimes are developed small open economies, such as Canada, Australia, Sweden.The basic debate between fixed and floating exchange rate regimes is mentioned in most principle of macroeconomics textbooks, where the Mundell–Fleming model is presented to explain the exchange rate regimes. Three, potentially desirable policies, are called "impossible trinity" because a country could not achieve all three at the same time.
- fixed exchange rate
- open to capital flows
- independent central bank and monetary policy
In practice, a central bank would not ignore substantial movements in exchange rate. Most monetary authorities in emerging market economies have two implicit targets, they aim to maintain a low inflation while also avoiding large currency movements.
Central banks in emerging economies will usually intervene to stabilize the currency when there is too much fluctuation in a short time period by using policy instruments. Thus, a pure floating exchange rate regime is quite rare in reality, most of floating currencies may be classified as a "managed float". However, the extent to which some developing countries control the fluctuation in nominal exchange rates appears to go beyond merely dampening large exchange rate changes. Other reasons are required to justify this "fear of floating" phenomenon.
Empirical evidence
To find out empirical statistics to assess this phenomenon, we could consider some countries with relatively pure floating regimes as benchmark cases, for example United States and Japan. After calculating the monthly variation in percentage for developing countries in data sample, Calvo and Reinhart constructed a statistic to measure the flexibility of exchange rate. They compute the probability that the monthly change in the nominal exchange rate lies inside the 2.5 percent band. A higher probability implies a less flexible exchange rate time series.As indicated in Table 1 of Calvo and Reinhart, the probability is 58.7% for United States and 61.2% for Japan. Nevertheless, for developing countries who are classified as floaters, the probability on average reaches 77.4%.
This is even more surprising since in conventional wisdom, developing countries are subject to larger shocks. These statistics reveals preference for a relative stable exchange rate fluctuations in developing countries with floating exchange rate, or "fear of floating".
Following this preference for low variability in exchange rate, these countries try to smooth out exchange rate fluctuations though they announced intentions to float. In practice, the monetary authorities achieve so by two instruments, actively intervening in the foreign exchange markets and engaging in an active interest rate defense of the currency. These two policy reactions are also suggested by the data on interest rates and foreign reserves in emerging countries. The corresponding data indicates that there is a much larger variability in for international reserves and substantially smaller variation in interest rate in developing countries.
Here are a list of examples. More examples are provided by reviewing history of exchange rate regimes in different countries. Bolivia announced it would freely float in September 1985, but actually the exchange rate is not quite floating. It is closely pegged to the US dollar so that the regime was reclassified as a managed float.
In recent Asian financial crisis in 1997–1998, there is a substantial output drop as well as high inflation associated with a large decline in currency value. Although Korea and Thailand adopt the new floating regime, they seem to accumulate foreign reserves by control the exchange rate with intervention in the foreign market. This could be regarded as precautionary accumulation of international reserves to avoid similar financial crisis as 1997-98 crisis in the future. It is also claimed that by tying their currencies to the dollar, Asian governments are creating global economic strains, the fear of floating does exist in Asian emerging economies.
There also is evidence that the predominance of foreign currency liabilities in the banks’ balance sheets in Turkey induces a selling pressure in the exchange market as well as a fear of floating.
Explanations
Why might a country prefer a smooth exchange rate with low volatility and be reluctant to float the currency? A free floating exchange rate would increase foreign exchange volatility. The volatility might be very large during crisis period. This could cause serious problems, especially in emerging economies.Financial dollarization and original sin
Firstly, financial dollarization is one main reason against floating exchange rate. It refers to the situations where liabilities are denominated in foreign currencies while assets are in the local currency. Consequently. liability dollarization is also used interchangeably with currency mismatch. Under this currency mismatch, an unexpected depreciation of local currency would deteriorate bank and corporation's balance sheets, and the shrink in asset relative to foreign currency debts would threaten the stability of the financial system in local country. In countries with significant currency mismatches, the balance sheet effect is quite substantial, ignoring the high exchange rate volatility can prove to be very costly. This could provide an argument for sterilized foreign market intervention.The situation that "most developing countries are not able to borrow abroad in their domestic currency" is referred to "original sin" in economics literature. Original sin is present among most of the developing economies, especially in periods with high inflation rate and currency depreciation. This global capital market imperfection contributes a lot to the widespread liability dollarization phenomenon. International transaction costs, network externalities, lack of credible domestic policies and underdeveloped local bond market are claimed to be the main reasons to the original sin.
Contractionary depreciation
The cases of fear of floating mainly focus on the case of currency depreciation. Following the currency mismatch channel and balance sheet effects above, there is an output cost associated with depreciation of domestic currency, sometimes this adverse effect in output is called contractionary depreciation/devaluation.More generally, uncertainty in real exchange rate would reduce investment, and thus generating extra output costs. Actually, volatility affects economic growth not only through its direct impact on lowering investment, but may also harm productivity growth by affecting the efficiency of investment allocation. For example, some economists find strong evidence of how relative price volatility affect sectoral allocation of investment away from what total factor productivity differences would indicate. Furthermore, to smooth out exchange rate fluctuations, emerging countries are usually engaged in an active interest rate defense of the currency. There is also an output cost of raising interest rates. In a model with nominal wage rigidities, changes in exchange rate implies changes in actual real wage. As a result, "involuntary unemployment" and "voluntary unemployment" would arise due to labor market wage distortions.
If these output costs due to exchange rate fluctuations are sufficiently large relative to the cost of intervention, it is optimal of the decision maker to stabilize the exchange rate.