“WAIT AND SEE” OR “FEAR OF FLOATING”?

This paper studies the evolution of China’s exchange rate policy using real options theory. With intervention costs and ongoing uncertainty, intervention involves the exercise of an option. Increased uncertainty increases the value of this option. This “wait and see” effect leads the Central Bank to widen its intervention band. However, increased volatility also produces larger fluctuations in welfare, which creates a “fear of floating.” This induces the Central Bank to set a tighter band. To study this trade-off, our paper incorporates stochastic volatility into a new Keynesian target zone model and then calibrates it to data from China. We find that increased uncertainty leads to a tighter intervention band, both in the data and in the model. Hence, in China, “fear of floating” appears to dominate the “wait and see” effect.

Comfort in Floating

Chile offers an example of a country that has overcome the fear of floating by reducing balance sheet mismatches, enhancing financial market development, as well as improving monetary, fiscal, and political institutions, and strengthening policy credibility. Under the floating regime, Chile’s economic adjustment to external shocks appears significantly improved, and its exchange rate pass-through has substantially declined. Our results reinforce the case that moving to a clear and credible floating regime can be associated with a reduction in the fear of floating via economic transformation (like smaller balance sheet mismatches, a larger hedging market, and a lower exchange rate pass-through).

Testing the ‘Fear of Floating’ Hypothesis: A Statistical Analysis for Eight African Countries

This paper revisits the fear of floating hypotheses for eight African countries from the collapse of the Bretton Woods fixed exchange rate system in the early 1970s up until December 2017. This long period of calendar time allows us to extend previous studies by examining the fear of floating hypotheses in two distinct ways. First, we look at a set of descriptive statistics to compare the degree of exchange rate flexibility under alternative de jure exchange rate regimes. We find no statistical difference between exchange volatility between declared floaters and fixers, but greater reserve volatility between the floaters, which is suggestive of fear of floating. Second, we use a non-linear, threshold VAR model, estimated for each country, to test for a relationship between exchange rate changes and reserve changes. The results suggest some evidence of a fear of floating for countries which have declared a de jure floating regime, with the regime-dependent impulse responses indicating that exchange rate appreciation due to positive reserve shocks is more prevalent in the high reserve regimes, indicative that level of foreign reserves available are important for their exchange rate policies. In general, although the countries with de jure floating regimes have a lower threshold than those with pegged regimes, reserves adjust by more than the exchange rates showing a fear of floating.

The New Drivers of Fear of Floating: Evidence from Latin America

There exists a consensus in the literature that during the 90s the main reason for fear of floating in emerging economies was the excessive liabilities dollarization, both in private and public sectors, which resulted in central banks’ interventions over the exchange rate. The main objective of these interventions was preventing the negative balance sheet effects originated by currency depreciations. Latin America certainly fits in this description, as convincingly documented by Calvo and Reinhart (Calvo, Guillermo A., and Carmen M. Reinhart. 2002. “Fear of Floating.” Quarterly Journal of Economics 117 (2): 379–408.). However, Latin American economies have reduced their debt in foreign currency since the early 2000s. Moreover, these economies extensively increased their amount of international reserves in the last decade and some of them – like Colombia and Mexico – have even reached the IMF’s flexible credit line, which operates as an international lender of last resort. All these changes – lower liability dollarization, higher international reserves, and new collaterals – suggest that the fear of devaluating in Latin America should be lower. Nevertheless, floating has not been the decision in terms of exchange rate policy. Conversely, most of Latin American countries that announced free floating opted for managed floating regimes and discretional interventions, in what can be considered as a new era of fear of floating. This paper finds empirical evidence that the main motivation for fear of floating has changed during the recent boom in commodity prices, 2005–2013, when foreign exchange interventions under flexible regimes were focused on avoiding excessive currency appreciations and apparently preventing Dutch disease.

ANALYSIS OF EXCHANGE RATE PASS-THROUGH, FEAR OF FLOATING, AND IMPLEMENTATION OF INFLATION TARGETING FRAMEWORK

This paper analyze the exchange rate pass-through and fear of floating behavior on 18 countries that adopting Inflation Targeting Framework (ITF). Vector Error Correction Model (VECM) is used: (1) to estimate the effect of exchange rate depreciation to inflation (passthrough); and (2) to examine the indication of fear of floating behavior. The result shows that passthrough effect has decreased in most countries after ITF where middle income countries have higher passthrough than high income countries. This effect did not disappear completely and still has a significant role to drive inflation. The interventions on exchange rate movement can be interpreted more as control of inflation than fear of floating. The implementation of ITF especially in middle income countries needs further to be reconsidered since it requires inflation as the only nominal anchor.

ANALYSIS OF EXCHANGE RATE PASS-THROUGH, FEAR OF FLOATING, AND IMPLEMENTATION OF INFLATION TARGETING FRAMEWORK

This paper analyze the exchange rate pass-through and fear of floating behavior on 18 countries that adopting Inflation Targeting Framework (ITF). Vector Error Correction Model (VECM) is used: (1) to estimate the effect of exchange rate depreciation to inflation (passthrough); and (2) to examine the indication of fear of floating behavior. The result shows that passthrough effect has decreased in most countries after ITF where middle income countries have higher passthrough than high income countries. This effect did not disappear completely and still has a significant role to drive inflation. The interventions on exchange rate movement can be interpreted more as control of inflation than fear of floating. The implementation of ITF especially in middle income countries needs further to be reconsidered since it requires inflation as the only nominal anchor.