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The economic determinants of the choice of an exchange rate regime: a probit analysis
Economics Letters 59 (1998) 283–287
The economic determinants of the choice of an exchange rate regime: a probit analysis Jean-Marc Rizzo* Faculty of Economics, Mediterranean University, Aix-en-Provence, France Received 12 August 1997; accepted 11 February 1998
Abstract Probit models were used to analyze the choice of exchange rate regimes by developing countries in the period 1977–1995. The results show the preeminence of criteria postulated in the theory of optimum currency areas, i.e., individual structural characteristics. 1998 Elsevier Science S.A. Keywords: Exchange rate regime choice; Developing countries; Probit model JEL classification: C25; F33
1. Introduction Since the work by Dreyer (1978); Heller (1978) or Holden et al. (1979), few empirical studies had been devoted to the question of the choice of exchange rate regime. Recently, however, the question has returned to the fore through, in particular, the contributions of Honkapohja and Pikkarainen (1994) and Edwards (1996). Most of the studies published to date, however, fail to distinguish between developing countries and developed countries, and merely consider the importance of criteria stemming directly from the theory of optimum currency areas. As for the results themselves, these appear to be diverse and somewhat contradictory. Our study, concentrated on the developing countries, uses the largest sample of countries and the longest period (1977–1995) examined up to now. It also departs from the strict framework of optimum currency areas and investigates the validity of variables never previously tested. At econometric level, it uses, as do most recent studies, a discrete choice model. 2. The model The exchange rate regimes in force in developing countries during the period studied have been *CEFI, Chateau ˆ Lafarge—Route des Milles, 13290 Les Milles, France. Tel.: 33 442 935993; fax: 33 442 389585; e-mail: [email protected] 0165-1765 / 98 / $19.00 1998 Elsevier Science S.A. All rights reserved. PII: S0165-1765( 98 )00056-1
284
J. Rizzo / Economics Letters 59 (1998) 283 – 287
differentiated, using the IMF classification, into four groups: Group 1, consisting of countries which peg their domestic currency to a single foreign currency; Group 2, countries which have chosen to peg to a basket of currencies; Group 3, countries adopting limited flexibility; Group 4, countries which let their domestic currency fluctuate freely. It should be noted that Group 3 embraces a number of ` different exchange rate arrangements: limited flexibility vis-a-vis a single currency, exchange rate adjustment according to a set of indicators and other managed float arrangements. The period covered was divided in five subperiods: 1977–1980, 1981–1984, 1985–1988, 1989– 1992 and 1993–1995, chosen by reference to key episodes of developing countries’ recent economic history. 1977–1980 evokes the first stage of free choice of exchange rate system; 1981–1984 is a period during which most developing countries faced serious difficulties, being simultaneously confronted with exogenous shocks and international credit limitations; 1985–1988 corresponds to a period of increasing influence exerted by the IMF and the World Bank, bodies within which the members favorable to flexible exchange rates were themselves particularly influential; 1989–1992 was a period during which there were two conflicting theories within the IMF and the World Bank, the one favorable to flexible rates and the other—supported by their European members—recommending a return to fixed rates; 1993–1995 represents the current situation. The choice of these three-to-four-year periods also responds to a separate consideration, of a technical nature. The developing-country time series are not only discontinuous, but also unreliable for some years. Taking periods of a number of years and calculating for each country and each variable an average over the period considered makes it possible to minimize the influence of dubious data and to eliminate the problem of missing data. Furthermore, this procedure reduces the simultaneity problems in econometric regressions. As for the exchange rate regimes, we have taken the situation of each country to be that ruling on 31 December of the last year of the subperiod concerned.
3. The econometric results and their implications In this section, we present the results of a PROBIT analysis (see Table 1). The models were tested in binomial and ordered multinomial versions. In the binomial regressions, the dependent variable (the exchange rate regime choice), takes the value of 0 (groups 1 and 2) or 1 (groups 3 and 4) and so opposes fixed exchange rate regimes to flexible exchange rate regimes. In the multinomial version, the dependent variable takes the value of 0 (group 1), 1 (group 2) or 2 (groups 3 and 4). The results should dispel the scepticism that sometimes surrounds the view that the choice of exchange rate regime stems from the theory of optimum currency areas. The size, the level of economic development, the degrees of openness and geographical diversification of foreign trade have in practice a significant power in explaining the developing countries’ choices throughout the 1977–1995 period. However, these factors have not always acted according to the predictions of the theory. While larger countries and those whose trade is the most diversified have, as anticipated, tended to opt for flexibility, the less open countries have not. The degree of openness has in fact proved to be associated with flexible exchange rates, probably because they facilitate the absorption of foreign shocks. As for the most developed countries, these did indeed opt for flexibility at the beginning of the
J. Rizzo / Economics Letters 59 (1998) 283 – 287
285
Table 1 Choice of exchange rate regime, regressions results 1977–1980 Binom. SIZE
2 0.012
Multinom. 2 0.012
(2.38)**
1985–1988
Binom.
Binom.
2 0.009
(2.77)*** 2 0.31
DVPT
1981–1984
(2.51)** 2 0.27
(2.53)** GDIV
(1.88)*
0.067
0.021
0.030
(1.83)*
(1.88)*
(2.30)**
2 0.013
1989–1992 Multinom. 2 0.014
(2.83)***
(3.27)***
0.43
0.17
(2.89)***
(2.82)***
0.019 (3.84)***
0.018 (1.75)*
(2.20)**
0.09 (2.08)**
2 0.006 (2.63)*** 0.10 (2.29)**
2 0.004 (2.14)** 0.06 (1.92)*
0.017
0.008
0.013
(1.79)*
(2.43)**
(1.72)*
2 1.73
2 0.93
(2.02)**
(1.38) 0.014 (1.66)*
(1.65)* BALC
9.52 (2.03)**
RESV
2 4.92
(0.89)
(2.66)*** 2 2.41
(1.7)* 6.38
2 0.14
2 6.29
(2.10)**
5.69
(2.13)**
(1.96)**
0.013
(2.73)***
4.9
2 0.003
Multinom.
(2.27)**
2 0.4
GEXP
0.15
0.021
DEBT
GREV or
(2.26)**
Binom.
0.007
(2.47)** TERMS
2 0.004
Multinom.
(1.88)*
2 2.42
OPEN
Binom.
1993–1995
2 2.86
(2.38)**
2 1.68
(2.71)***
(1.89)*
4.29
(2.97)***
(2.64)***
2 11.43
PDEF
(2.89)*** INFL
2 0.04
2 0.04
(3.25)***
2 0.006
(2.96)***
(1.86)*
2 0.033
2 0.028
(2.49)**
(1.99)**
2 0.076 (5.25)***
2 0.074 (5.40)***
2 0.015 (2.80)***
2 0.059 (4.07)***
2 26.37
2 60.22
2 37.09
2 55.50
2 104.46
2 54.28
2 85.55
2 70.03
2 99.45
Chi-squared
39.47
46.28
31.52
53.14
44.71
55.03
49.78
30.45
36.92
% of correct
85.7
57.7
78.7
78.4
56.5
75.4
68.9
73.2
66.7
Log-likelihood
predictions Number of
84
78
89
125
117
118
103
123
117
observations
1. Multinomial regression is reported when it is of at least as good quality as the binomial. 2. Absolute t-statistics are displayed in parentheses under the coefficient estimates. *: test-statistic is significant at the 10% level; **: significant at the 5% level; ***: significant at the 1% level. Scale of coefficients SIZE and DVPT: 10 23 . Constant terms are not reported. 3. SIZE is measured by GDP; DVPT, level of economic development, by GDP per capita; GDIV, geographical diversification of trade, by the percentage share of the three largest export destinations; OPEN, degree of openness, by the ratio of exports to GDP. TERMS is the terms of trade; DEBT the external debt (ratio to GDP); BALC the current-account balance (ratio to GDP); RESV the foreign currency reserves (ratio to GDP); GREV and GEXP, government revenue and expenditure (ratios to GDP); PDEF the public deficit (ratio to GDP); INFL, the rate of inflation.
period, but around the mid-1980s the process was clearly reversed and nowadays a majority of poor countries belong to the ‘‘floater’’ group. Analysis of the link between the exchange rate regime and inflation brings out one clear conclusion: a relationship between the two does indeed exist (even if its etiology remains uncertain). Countries with low inflation tend to have fixed rather than flexible exchange rates. As regards the variables falling outside the scope of the theory of optimum currency areas, the results appear less convincing. The levels of the external debt and the public deficit clearly do not
286
J. Rizzo / Economics Letters 59 (1998) 283 – 287
have any significant explanatory power, terms of trade not much, government revenue (expenditure) only at the beginning of the period, and the current-account balance only inconsistently. Foreigncurrency reserves provide the only point of interest. From 1985 to 1995 this variable is significant only in ordered multinomial regressions, which seems to make it one of the determinants of the choice between the two ways of fixing the exchange rate, in that countries with larger reserves tend to peg to a basket of currencies.
4. Conclusion Clearly, individual structural characteristics have exercised an influence on the choice of exchange rate regime all through the period studied. They were probably not the only factors involved, but it seems to us excessive to treat them as being of only marginal relevance, as do Melvin (1985) or Honkapohja and Pikkarainen (1994). Even though some factors have not been considered here (financial markets, currency black markets, commodity concentration of foreign trade), the factors taken into account are enough to bring out the existence of a long-term economic rationale.
Acknowledgements I would like to thank Charles Lai Tong, Lindsay Pointu and Francis Wells.
Appendix 1
Data Sources African Development Indicators (various issues), The World Bank. Direction of Trade Statistics (various issues), International Monetary Fund. Economist Intelligence Unit database, The Economist. International Financial Statistics (various issues), International Monetary Fund. Statistical Yearbook (various issues), United Nations. Trends in Developing Economies (various issues), The World Bank. World Debt Tables (various issues), The World Bank. World Tables (various issues), The World Bank.
References Dreyer, J.S., 1978. Determinants of exchange rate regimes for currencies of developing countries: some preliminary results. World Development 6 (2), 437–445. Edwards, S., 1996. The determinants of the choice between fixed and flexible exchange-rate regimes. NBER Working Paper Series 5756.
J. Rizzo / Economics Letters 59 (1998) 283 – 287
287
Heller, H.R., 1978. Determinants of exchange rate practices. Journal of Money, Credit, and Banking 10 (3), 308–321. Holden, P., Holden, M., Suss, E.C., 1979. The determinants of exchange rate flexibility: an empirical investigation. Review of Economics and Statistics 61 (3), 327–333. Honkapohja, S., Pikkarainen, P., 1994. Country characteristics and the choice of the exchange rate regime: are mini-skirts followed by maxis? In: Akerholm, J., Giovannini, A. (Eds.), Exchange Rate Policies in the Nordic Countries, CEPR, London, pp. 31–53. Melvin, M., 1985. The choice of an exchange rate system and macroeconomic stability. Journal of Money, Credit, and Banking 17 (4), 467–478.
The economic determinants of the choice of an exchange rate regime: a probit analysis Jean-Marc Rizzo* Faculty of Economics, Mediterranean University, Aix-en-Provence, France Received 12 August 1997; accepted 11 February 1998
Abstract Probit models were used to analyze the choice of exchange rate regimes by developing countries in the period 1977–1995. The results show the preeminence of criteria postulated in the theory of optimum currency areas, i.e., individual structural characteristics. 1998 Elsevier Science S.A. Keywords: Exchange rate regime choice; Developing countries; Probit model JEL classification: C25; F33
1. Introduction Since the work by Dreyer (1978); Heller (1978) or Holden et al. (1979), few empirical studies had been devoted to the question of the choice of exchange rate regime. Recently, however, the question has returned to the fore through, in particular, the contributions of Honkapohja and Pikkarainen (1994) and Edwards (1996). Most of the studies published to date, however, fail to distinguish between developing countries and developed countries, and merely consider the importance of criteria stemming directly from the theory of optimum currency areas. As for the results themselves, these appear to be diverse and somewhat contradictory. Our study, concentrated on the developing countries, uses the largest sample of countries and the longest period (1977–1995) examined up to now. It also departs from the strict framework of optimum currency areas and investigates the validity of variables never previously tested. At econometric level, it uses, as do most recent studies, a discrete choice model. 2. The model The exchange rate regimes in force in developing countries during the period studied have been *CEFI, Chateau ˆ Lafarge—Route des Milles, 13290 Les Milles, France. Tel.: 33 442 935993; fax: 33 442 389585; e-mail: [email protected] 0165-1765 / 98 / $19.00 1998 Elsevier Science S.A. All rights reserved. PII: S0165-1765( 98 )00056-1
284
J. Rizzo / Economics Letters 59 (1998) 283 – 287
differentiated, using the IMF classification, into four groups: Group 1, consisting of countries which peg their domestic currency to a single foreign currency; Group 2, countries which have chosen to peg to a basket of currencies; Group 3, countries adopting limited flexibility; Group 4, countries which let their domestic currency fluctuate freely. It should be noted that Group 3 embraces a number of ` different exchange rate arrangements: limited flexibility vis-a-vis a single currency, exchange rate adjustment according to a set of indicators and other managed float arrangements. The period covered was divided in five subperiods: 1977–1980, 1981–1984, 1985–1988, 1989– 1992 and 1993–1995, chosen by reference to key episodes of developing countries’ recent economic history. 1977–1980 evokes the first stage of free choice of exchange rate system; 1981–1984 is a period during which most developing countries faced serious difficulties, being simultaneously confronted with exogenous shocks and international credit limitations; 1985–1988 corresponds to a period of increasing influence exerted by the IMF and the World Bank, bodies within which the members favorable to flexible exchange rates were themselves particularly influential; 1989–1992 was a period during which there were two conflicting theories within the IMF and the World Bank, the one favorable to flexible rates and the other—supported by their European members—recommending a return to fixed rates; 1993–1995 represents the current situation. The choice of these three-to-four-year periods also responds to a separate consideration, of a technical nature. The developing-country time series are not only discontinuous, but also unreliable for some years. Taking periods of a number of years and calculating for each country and each variable an average over the period considered makes it possible to minimize the influence of dubious data and to eliminate the problem of missing data. Furthermore, this procedure reduces the simultaneity problems in econometric regressions. As for the exchange rate regimes, we have taken the situation of each country to be that ruling on 31 December of the last year of the subperiod concerned.
3. The econometric results and their implications In this section, we present the results of a PROBIT analysis (see Table 1). The models were tested in binomial and ordered multinomial versions. In the binomial regressions, the dependent variable (the exchange rate regime choice), takes the value of 0 (groups 1 and 2) or 1 (groups 3 and 4) and so opposes fixed exchange rate regimes to flexible exchange rate regimes. In the multinomial version, the dependent variable takes the value of 0 (group 1), 1 (group 2) or 2 (groups 3 and 4). The results should dispel the scepticism that sometimes surrounds the view that the choice of exchange rate regime stems from the theory of optimum currency areas. The size, the level of economic development, the degrees of openness and geographical diversification of foreign trade have in practice a significant power in explaining the developing countries’ choices throughout the 1977–1995 period. However, these factors have not always acted according to the predictions of the theory. While larger countries and those whose trade is the most diversified have, as anticipated, tended to opt for flexibility, the less open countries have not. The degree of openness has in fact proved to be associated with flexible exchange rates, probably because they facilitate the absorption of foreign shocks. As for the most developed countries, these did indeed opt for flexibility at the beginning of the
J. Rizzo / Economics Letters 59 (1998) 283 – 287
285
Table 1 Choice of exchange rate regime, regressions results 1977–1980 Binom. SIZE
2 0.012
Multinom. 2 0.012
(2.38)**
1985–1988
Binom.
Binom.
2 0.009
(2.77)*** 2 0.31
DVPT
1981–1984
(2.51)** 2 0.27
(2.53)** GDIV
(1.88)*
0.067
0.021
0.030
(1.83)*
(1.88)*
(2.30)**
2 0.013
1989–1992 Multinom. 2 0.014
(2.83)***
(3.27)***
0.43
0.17
(2.89)***
(2.82)***
0.019 (3.84)***
0.018 (1.75)*
(2.20)**
0.09 (2.08)**
2 0.006 (2.63)*** 0.10 (2.29)**
2 0.004 (2.14)** 0.06 (1.92)*
0.017
0.008
0.013
(1.79)*
(2.43)**
(1.72)*
2 1.73
2 0.93
(2.02)**
(1.38) 0.014 (1.66)*
(1.65)* BALC
9.52 (2.03)**
RESV
2 4.92
(0.89)
(2.66)*** 2 2.41
(1.7)* 6.38
2 0.14
2 6.29
(2.10)**
5.69
(2.13)**
(1.96)**
0.013
(2.73)***
4.9
2 0.003
Multinom.
(2.27)**
2 0.4
GEXP
0.15
0.021
DEBT
GREV or
(2.26)**
Binom.
0.007
(2.47)** TERMS
2 0.004
Multinom.
(1.88)*
2 2.42
OPEN
Binom.
1993–1995
2 2.86
(2.38)**
2 1.68
(2.71)***
(1.89)*
4.29
(2.97)***
(2.64)***
2 11.43
PDEF
(2.89)*** INFL
2 0.04
2 0.04
(3.25)***
2 0.006
(2.96)***
(1.86)*
2 0.033
2 0.028
(2.49)**
(1.99)**
2 0.076 (5.25)***
2 0.074 (5.40)***
2 0.015 (2.80)***
2 0.059 (4.07)***
2 26.37
2 60.22
2 37.09
2 55.50
2 104.46
2 54.28
2 85.55
2 70.03
2 99.45
Chi-squared
39.47
46.28
31.52
53.14
44.71
55.03
49.78
30.45
36.92
% of correct
85.7
57.7
78.7
78.4
56.5
75.4
68.9
73.2
66.7
Log-likelihood
predictions Number of
84
78
89
125
117
118
103
123
117
observations
1. Multinomial regression is reported when it is of at least as good quality as the binomial. 2. Absolute t-statistics are displayed in parentheses under the coefficient estimates. *: test-statistic is significant at the 10% level; **: significant at the 5% level; ***: significant at the 1% level. Scale of coefficients SIZE and DVPT: 10 23 . Constant terms are not reported. 3. SIZE is measured by GDP; DVPT, level of economic development, by GDP per capita; GDIV, geographical diversification of trade, by the percentage share of the three largest export destinations; OPEN, degree of openness, by the ratio of exports to GDP. TERMS is the terms of trade; DEBT the external debt (ratio to GDP); BALC the current-account balance (ratio to GDP); RESV the foreign currency reserves (ratio to GDP); GREV and GEXP, government revenue and expenditure (ratios to GDP); PDEF the public deficit (ratio to GDP); INFL, the rate of inflation.
period, but around the mid-1980s the process was clearly reversed and nowadays a majority of poor countries belong to the ‘‘floater’’ group. Analysis of the link between the exchange rate regime and inflation brings out one clear conclusion: a relationship between the two does indeed exist (even if its etiology remains uncertain). Countries with low inflation tend to have fixed rather than flexible exchange rates. As regards the variables falling outside the scope of the theory of optimum currency areas, the results appear less convincing. The levels of the external debt and the public deficit clearly do not
286
J. Rizzo / Economics Letters 59 (1998) 283 – 287
have any significant explanatory power, terms of trade not much, government revenue (expenditure) only at the beginning of the period, and the current-account balance only inconsistently. Foreigncurrency reserves provide the only point of interest. From 1985 to 1995 this variable is significant only in ordered multinomial regressions, which seems to make it one of the determinants of the choice between the two ways of fixing the exchange rate, in that countries with larger reserves tend to peg to a basket of currencies.
4. Conclusion Clearly, individual structural characteristics have exercised an influence on the choice of exchange rate regime all through the period studied. They were probably not the only factors involved, but it seems to us excessive to treat them as being of only marginal relevance, as do Melvin (1985) or Honkapohja and Pikkarainen (1994). Even though some factors have not been considered here (financial markets, currency black markets, commodity concentration of foreign trade), the factors taken into account are enough to bring out the existence of a long-term economic rationale.
Acknowledgements I would like to thank Charles Lai Tong, Lindsay Pointu and Francis Wells.
Appendix 1
Data Sources African Development Indicators (various issues), The World Bank. Direction of Trade Statistics (various issues), International Monetary Fund. Economist Intelligence Unit database, The Economist. International Financial Statistics (various issues), International Monetary Fund. Statistical Yearbook (various issues), United Nations. Trends in Developing Economies (various issues), The World Bank. World Debt Tables (various issues), The World Bank. World Tables (various issues), The World Bank.
References Dreyer, J.S., 1978. Determinants of exchange rate regimes for currencies of developing countries: some preliminary results. World Development 6 (2), 437–445. Edwards, S., 1996. The determinants of the choice between fixed and flexible exchange-rate regimes. NBER Working Paper Series 5756.
J. Rizzo / Economics Letters 59 (1998) 283 – 287
287
Heller, H.R., 1978. Determinants of exchange rate practices. Journal of Money, Credit, and Banking 10 (3), 308–321. Holden, P., Holden, M., Suss, E.C., 1979. The determinants of exchange rate flexibility: an empirical investigation. Review of Economics and Statistics 61 (3), 327–333. Honkapohja, S., Pikkarainen, P., 1994. Country characteristics and the choice of the exchange rate regime: are mini-skirts followed by maxis? In: Akerholm, J., Giovannini, A. (Eds.), Exchange Rate Policies in the Nordic Countries, CEPR, London, pp. 31–53. Melvin, M., 1985. The choice of an exchange rate system and macroeconomic stability. Journal of Money, Credit, and Banking 17 (4), 467–478.