It is time to rethink the exchange rate orthodoxy for open economies

Unlock Editor’s Digest for free

FT editor Roula Khalaf selects her favorite stories in this weekly newsletter.

The writer is chief economist at the Inter-American Development Bank

From the collapse of Argentina’s convertibility regime in the early 2000s to recent discussions of the case for greater exchange rate flexibility for China, the past two decades have seen heated debate about the optimal exchange rate regime for large economies and small.

This debate has been supported by an influential academic consensus that the only sustainable regimes are hard currency pegs or free floating exchange rates – the so-called “bipolar view”.

However, real-world experiences in many countries have long suggested that this dichotomy is too simplistic. Strong volatility in several countries has raised concerns about currency instability and “pass-through” to inflation. Meanwhile, the relative stability of economies such as Singapore during the pandemic has highlighted the potential benefits of using the exchange rate as a monetary policy tool.

Rather than targeting interest rates, the Monetary Authority of Singapore manages the Singapore dollar’s exchange rate against a trade-weighted basket of currencies. The MAS adjusts the rate of appreciation or depreciation to meet its inflation targets, essentially carrying out inflation targeting but with the exchange rate as an instrument. It’s a novel approach that has produced impressive results: since the 1980s, Singapore has enjoyed low inflation, high growth and remarkable resilience to shocks.

Against this backdrop, a new study by the Inter-American Development Bank offers a rigorous economic rationale for Singapore’s framework, at least for economies that are highly open to trade. Using macroeconomic models calibrated to data from Singapore and Chile, the study finds that exchange rate management can provide significant welfare gains – equivalent to a permanent 1.5% increase in consumption – for highly open economies such as Singapore, where exports and imports totals almost three times. GDP.

The reason is simple. In a highly open economy, exchange rate volatility has a huge impact on inflation, output and living standards. By adjusting the pace of currency appreciation or depreciation, monetary authorities can tame this volatility and provide greater macroeconomic stability.

The problem is that the benefits of a managed exchange rate increase with trade openness. For Chile, the study estimates that switching to a Singapore-style system would reduce welfare by 0.5 percent, given current levels of trade of about 70 percent of GDP. But if Chile’s trade grew to more than 100% of GDP, the calculus would reverse, and the case for managed float would start to look better than free float.

This suggests that the optimal exchange rate regime may evolve along with the structural characteristics of an economy. As developing economies integrate more deeply into global trade networks, they may need to consider a greater role for exchange rate management.

Of course, this does not mean that every open economy should adopt Singapore-style exchange rate targeting. A managed float can increase vulnerability to speculative attacks or sudden stop crises in countries with low central bank credibility or significant foreign currency debt. But the central idea—that the optimal degree of exchange rate flexibility depends crucially on trade openness—is an important one for policymakers.

The lesson is that no exchange rate regime is right for all countries at all times. Policymakers in open economies should tailor their approach to their own circumstances, using exchange rate leverage judiciously to navigate an increasingly integrated but volatile global economy. Sometimes a little fear of floating may not be so irrational after all. As the global monetary order continues to evolve, it’s a lesson worth heeding.

The findings of this study suggest that intermediate regimes can be both sustainable and beneficial under certain conditions, especially for highly open economies. And as emerging economies continue to gain weight and economic influence, there may be increasing interest in alternative monetary frameworks that better suit their needs and circumstances.

The Singapore model, with its emphasis on using the exchange rate as a policy tool, could serve as a valuable template for countries seeking to balance the benefits of global integration with the imperative of domestic economic stability. This could lead to a more diverse and resilient global monetary landscape.