The Art of Gracefully Exiting a Peg
The wave of liberalization of capital movements, which swept Europe in the 1980s and the emerging market countries in the 1990s, has given rise to the two-corner strategy. According to this view only two exchange rate regimes are sustainable: hard pegs and fully flexible rates. Soft pegs in the middle are seen as doomed, open to irresistible and unpredictable speculative attacks and historical evidence shows clearly that increasing number of countries have exited the soft middle ground, mostly towards the flexible end of the spectrum. However, not all the exits from hard pegs to flexible arrangements are happy. Most countries hesitate to leave the peg when it is working properly, and consider exit option only when they are facing speculative pressure, and then it often is too late. This paper aims to analyze the factors contributing to peaceful exits, that is exiting without a significant loss in the value of the domestic currency. It seeks to find conditions that need to be satisfied to ensure an exit without significant economic costs. Historical record of exchange rate classification comes from Reinhart and Rogoff's path-breaking study on this subject, where they classified regimes on the basis of observed, de facto, currency movements rather than the announced, de jure, official rates. Some interesting results we have found may be put as follows: Cold-blooded exits enacted when the macroeconomic conditions are favorable, that is countries planning to leave a peg are advised to do it when it is least necessary and least expected. Another surprising result is that, efficient and deep financial markets do not help with exits. Countries encouraged to exit pegs before they fully liberalize their financial account and deepen their markets. The study covers the period 1975-2001. Our choice criteria provide 55 cases of exits, 27 of which is peaceful and the rest 28 cases troubled ones. We estimate non-structural probit models with monthly and annual data.
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