"Effects of Abandoning Fixed Exchange Rates for Greater Flexibility"
At the recent NBER ISOM conference, Andy Rose presented a paper entitled Flexing Your Muscles: Effects of Abandoning Fixed Exchange Rates for Greater Flexibility, coauthored with Barry Eichengreen, following up on this 2010 paper, evaluating the effects of flexing (VoxEU post here).
For purposes of this short paper we examine a
comprehensive data set covering over 200 countries and territories since 1957. ...
narrow our focus to 51 instances where countries abandoned currency pegs for regimes of
greater flexibility and allowed their exchange rates to appreciate. This permits us to examine
systematically the impact of these events, which we call "flexes," on a range of macroeconomic
and financial variables, including GDP growth, export growth, consumption, investment and
inflation. We look for and, if necessary, correct for selectivity bias by searching for differences
in country circumstances in the period before the decision to flex was taken....In a subset of cases, however,
the decision to flex is followed by a discernible slowdown in the rate of growth of the economy.
Slowdowns are most likely, we show, when the investment ratio is high, consumption,
investment, exports and imports are growing rapidly, and credit growth is rising. Since we only
have 51 observations, we cannot hope to be precise, but our results are robust in the case of
high investment rates and rapid import growth in particular; both of these presage a decline in
growth following flexing. The implication is that China may have some basis for worrying about
the growth effects of appreciating out of its fixed exchange rate regime.
In a subset of cases, the decision to flex was also followed by a significant decline in the
rate of inflation. Slower inflation is most likely, we show, in countries that are relatively open
to trade (where the reduction in the rate of import price inflation presumably has the greatest
impact) and with high foreign reserves (which had presumably been sterilizing capital inflows with less than complete success prior to the change in exchange rate regime). These results
also have obvious implications for China, which is currently characterized by inflation and the
other macroeconomic characteristics in question.
The discussion focused on some of the methodological issues; some of the identified "flexes" were associated with the end of the Bretton Woods system. The question then would be whether the lessons transferred from those episodes to more recent episodes.
In the conclusion, the authors highlight the implications for the debate of more rapid RMB revaluation.
At the same time, it is possible to pinpoint the kind of circumstances where the decision
to move to greater flexibility is likely to be followed by a significant economic slowdown. The
slowdown‐prone economies are those with exceptionally low consumption rates and high
investment rates. They are economies where exports and domestic credit have been growing
most rapidly. To put it simply, they are economies with Chinese characteristics.
These findings suggest that China may have had good reason to be cautious about not
moving away from its peg to the dollar too abruptly. But they also point to the kind of policy
reforms and macroeconomic rebalancing that the country should pursue in order to prepare
the way for its eventual adoption of a more flexible exchange rate.
I noted that in fact Chinese policymakers themselves had pointed out the need for slower, but higher quality, growth (see  ). In that sense, the paper's finding could not be taken as an unambiguous finding that revaluation/flexing would be a net negative for China.
Note that this event approach differs that of Kappler, Reisen, Schularik and Turkisch (2011) (discussed here, who included in their sample "step revaluations", i.e, revaluations from one pegged rate to another.