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Journal number 1 ∘ Davit Keshelava
Exchange Rate Regimes and Calvo-Reinhart Fear of Floating Index, Case Study of Georgia

Expanded Summary

Globalization of product and financial markets, and increasing economic reliance of countries make it important for monetary policymakers to choose an appropriate exchange rate regime, which will guarantee achieving and maintaining macroeconomic stability without harming economic growth significantly. According to the literature, different forms of floating and fixed exchange rate regimes have some advantages and disadvantages, and the choice in favor of them depends on the structure of the country’s economy, international economic and political relationships with the partner countries, and the level of financial development. However, adopting the managed floating or fixed exchange rate regimes (currency board, crawling peg, etc.) requires meeting the conditions of an optimal currency area proposed by Robert Mundell [Mindell, 1961]: 1) the participating countries should have similar business cycles; and 2) countries should have high level of labour and capital mobility to allow workers to move freely throughout the area and smooth out unemployment rate and in any single zone and eliminate regional trade imbalances.

The similarity of business cycles depends on the integration of partner countries in terms of external trade, money inflow, service export (including tourism), and foreign direct investment. Even though Georgia have some progress in diversifying its external trade, tourism and money inflow, the shares of the United States and European Union are still quite limited, and neighboring countries with relatively unstable currencies remain dominant in terms of economic relationship with Georgia.

Even though Georgia has visa-free travel to EU countries, there is no favorable situation for Georgia in terms of labor mobility due to legal difficulties that Georgia citizens tend to face in the EU labour market. Labor mobility is even lower in case of the Unites States – along with the cultural and economic barriers, Georgia does not have a visa-free regime with the United States. Low level of labor mobility hinders adjustment of inflation and unemployment within the optimal currency area and makes monetary policy relatively less efficient. Moreover, there is limited capital mobility between developed and developing countries. Although Georgia has no legal obstacles to invest / acquire in foreign capital, Georgia’s integration in the international financial markets remains quite limited. Hence, Georgia prefers to operate a with floating exchange rate, and maintain price stability with an inflation targeting system.              

However, sometimes declared (de jure) exchange rate regimes of the developing countries differ from the actual (de facto) exchange rate regimes. The difference between de jure and de facto exchange rate regimes are measured by the “Fear of Floating” (FoF) index, proposed by Calvo and Reinhart (2002). The FoF index includes three components (standard deviations of): exchange rate, monetary policy rate (discount rate) and official reserves. Higher the value of the index, lower is the “Fear of Floating”. For fixed exchange rate regimes FoF tend to equal zero. In 2008-2020 years, Georgia’s “Fear of Floating” index exceeded most of the countries in the region (e.g. Azerbaijan, Armenia, Kyrgyz Republic and Moldova), but lags the same measure for Belarus, Kazakhstan and Russia.

Georgia had one of the highest “Fear of Floating” in 2008-2015, when National Bank of Georgia (NBG) frequently intervened in the foreign exchange market to ensure exchange rate stability. However, it is notable that Georgia experienced two major currency crises during this period (global financial crisis in 2008, and regional oil crisis in 2015-2016). Hence, Georgia’s FoF index exceeded the same measures of only Azerbaijan and Moldova, while Azerbaijan operated within a fixed exchange rate regime that perfectly explains the low value of the index (quite close to zero). In general, countries in the region are characterized by a high level of “Fear of Floating”.

In contrast, Georgia had the lowest level of “Fear of Floating” (with the highest value of FoF index) among the countries in the wider region during 2016-2020. Hence, Georgia gives its national currency more freedom than the other countries. It is notable that Armenia and Azerbaijan have the lowest FoF indices among considered countries, which is not surprising in case of Azerbaijan, but remains as an interesting finding for Armenia - despite declared floating exchange rate regime, Central Bank of Armenia was actively employing its instruments (foreign currency interventions and contractionary monetary policy increasing interest rates in the economy) to maintain exchange rate stability.

In addition, for the majority of the countries, which are analyzed within this paper, interest rates tend to be more fluctuating than exchange rate and official reserves (which is in line with one of the major findings of Calvo and Reinhart (2002)). Hence, variation coefficients of the abovementioned three variables are quite similar in case of Georgia.

Literature suggests reasons behind having different declared (de jure) and actual (de facto) exchange rate regimes:

  • Countries with the experience of hyperinflation tend to have quite high “Fear of Floating”. Most of the Post-Soviets countries fall into this category [Belhocine et al, 2016].
  • Since the main mandate for most of the central banks is to maintain price stability, they sometimes intervene in the foreign exchange market to avoid the negative impact of exchange rate depreciation on price levels and inflation expectations. [Castro, 2004].
  • Developing countries, especially transition economies, are characterized by high levels of assets and liability dollarization. Hence, when currency depreciates, the debt burden is increasing for the people having income in national currency and debt in foreign currency (currency mismatch). Currency mismatch might create some problems in terms of financial stability (too many people become insolvent after waves of the currency depreciation), and generates political pressure on the Central Bank [Ranciere, Tornell & Vamvakidis, 2010].
  • Most of the developing countries do not have an opportunity to borrow in a national currency from the external sources. This phenomenon is called “Original Sin”, and provides incentives to the policymakers to cut short exchange rate fluctuations [Eichengreen, Hausmann & Panizza, 2002].