Global Development Horizons 2011
Implications for developing countries Historically, country choices over the exchange rate regime revolved more around issues of whether they would choose to fi x or float, with most pegs made vis-à-vis the U.S. dollar. With a multicurrency international regime, the choice of the reference currency—or currencies in the case of a basket—becomes more pertinent. The vast majority of developing countries, including those with the lowest incomes, would continue to transact internationally in currencies other than their own, and thus would be exposed to the exchange rate risk. Countries would therefore need to weigh standard considerations over the choice of a regime—such as the structural characteristics of the economy, the insulation properties of the regime, and the policy discipline conferred by a given choice (Frankel 1999)— along with whether pegging to a given international currency may be more optimal from the point of view of reducing volatility. Leaving the confines of a relatively fi xed-rate system would likely lead countries to experience significant increases in the volatility of both their nominal and real exchange rates. Developing countries with f loating exchange rate regimes may experience heightened foreign exchange volatility, especially if exchange rate movements among the leading-currency economies are uncoordinated and if they possess limited hedging capabilities.21 If the international currencies in a multipolar regime are indeed more volatile, then the volatility considerations that have
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already induced a “fear of floating” (Calvo and Reinhart 2002) in emerging economies may be compounded. Successfully managing a flexible regime also calls for proper policy frameworks, market microstructure, and financial institutions that can ensure the smooth functioning of foreign exchange markets (World Bank 2006). The fact that many developing countries, especially least developed countries, lack these necessary elements is probably why many have continued to choose some form of pegged regime (figure 3.12), and are likely to continue to do so even in a multicurrency system. However, whether the diversification benefits of pegging to a basket of the three main international currencies outweighs the costs of managing such a basket—as well as the optimal choice of weights within a basket—remains an open question. Furthermore, a move by a significant number of developing countries toward a nondollar-pegging regime—either via a peg to one of the other international currencies or to a basket— could also have implications for the system as a
FIGURE 3.12 Exchange rate arrangements of developing countries, 2000 and 2010 90
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80 countries or territories
international monetary system. Policy coordination would be facilitated if the focus is on goals that have the potential to benefit many countries in the same way: sustainable growth, financial stability, low inflation, and exchange rate stability. The initial successes of the G-20 have resulted from widespread concerns about the first two of those goals, along with a shared recognition that only a coordinated response could prevent a global economic meltdown during the fi nancial crisis. Sustaining the momentum of cooperation will require a long-term commitment to these goals.
Multipolarity in International Finance
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70 60 50 40 30 20
33
33
35
20
10 0 hard pegs
soft pegs 2000
floating
2010
Source: IMF 2000, 2010. Note: Classifications are based on the exchange rate arrangement classifications defined by the IMF (2010). Hard pegs include exchange rate arrangements of no separate legal tender and currency board; soft pegs for 2000 include other conventional fi xed peg arrangement, pegged exchange rate within horizontal bands, crawling peg, crawling band, and managed floating with no preannounced path for the exchange rate; soft pegs for 2010 include exchange rate arrangements of conventional peg, stabilized arrangement, crawling peg, crawl-like arrangement, pegged exchange rate within horizontal bands, and other managed arrangement; fl oating arrangements include floating and free fl oating.