Exit from Pegged Exchange Rate Regimes

How costly for an economy is an exit from a pegged exchange rate regime? The answer might provide some lessons for countries contemplating an exit from a common currency area such as the eurozone, the extreme case of a heavily managed exchange rate peg.

Recently Barry Eichengreen (Voxeu, 17 November 2007), apparently after searching extensively (and unsuccessfully) for good reasons why eurozone members should not even try to do that, claimed that he found the definitive answer: the euro is “effectively irreversible” because the prospect of a major post exit devaluation would incite “national households and firms to shift deposits to other Eurozone banks, producing a system-wide bank run.” Moreover the devaluation would increase the real burden of foreign-held, euro-denominated bonds, relative to national income, leading to defaults and bankruptcies.

In a previous post I noted that no bank run and no catastrophic financial crisis would take place if the euro itself had been devalued sufficiently in advance of the exit, so that a further devaluation of a national currency leaving the system would not be necessary.

I was not aware at the time of a paper by Joshua Aizenman and Reuven Glick, published in the June 2008 issue of the Journal of Money, Credit and Banking which analyzed the experience of several countries that exited pegged exchange rate regimes since 1980 (“Pegged Exchange Rate Regimes – A Trap?”) downloadable as a Federal Reserve Bank of San Francisco Working Paper.

The authors work on a data set assembled by IMF researchers Detragiache, Mody, and Okada in 2005, downloadable here.

They identify 63 episodes over the period 1980-2001 in which countries with heavily managed exchange rates ended in an exit, defined as a move to a more flexible exchange rate regime.

Interestingly, they define “disorderly” and “orderly” exits. An exit is deemed “disorderly” when the currency fell freely at some time during the 12 months period after the exit; the remaining episodes are deemed “orderly”. Indeed, this definition is not very different from what I defined as a condition for an exit not to be catastrophic: if there is no massive devaluation in the months following the exit they define it as “orderly”, while I concluded that none of the apocalyptic consequences that Eichengreen foretold would then take place. Indeed there is no need for the newly independent currency to fall freely if the very currency to which it was linked was massively devalued beforehand. In that case there will be no bank run, no financial crisis, and no major contraction of the economy.

In the data set under review, Aizenman and Glick note that, of the 63 exit episodes observed, 32 were “disorderly” and 31 “orderly”.

They further observe that overall, “economic growth typically slows in the periods leading up to the exit, is almost zero on average in the year after the exit occurs, following which growth recovers.”

Indeed, growth typically declines during the two years preceding the exit and during one year after the exit, while thereafter growth resumes. In fact two third of the growth decline is not due to exit but antedates it, and is leading to exit. It would thus be wrong to attribute all the contraction of the economy to the exit policy, since on the contrary exit helped the economy to recover.

Thus while it is clear that “… exits from pegged exchange rates have not occurred under favorable circumstances” (Eichengreen, “Kicking the habit: moving from pegged rates to greater exchange rate flexibility”, Economic Journal, March 1999) it is not correct to conclude that “They have not had happy results.” (Eichengreen, 1999). Except, of course, if you define recovery after a crisis a “not happy result”.

Another interesting conclusion from the paper is that “the longer the duration of a pegged exchange rate regime, the lower (greater) is the output growth (decline).” And this effect is even more pronounced in the case of disorderly exits.

A clear warning for eurozone members who are currently seriously affected by disequilibrium implicit real exchange rates (degraded competitiveness) within the euro: do not wait too much to exit. Act now.