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Fear of floating refers to a country prefers a smoother exchange rate to a floating exchange rate regime. This is more relevant in emerging economies, especially when they suffered from financial crisises in last two decades.

In foreign exchange markets of the emerging market economies, there is evidence showing that countries who claim they are floating their currency, are actually reluctant to let the nominal exchange rate fluctuate in response to macroeconomic shocks. In the literature, this is first convincingly documented by Calvo and Reinhart with “fear of floating” as the title of their paper. Therefore, this widespread phenomenon of reluctance to adjust exchange rate in emerging markets is usually called “fear of floating” thereafter. In addition, fear of floating and exchange rate volatility are used interchangeable in other studies.

Floating vs. fixed exchange rate
To understand the benifits and costs of floating the currency, we need to make a simple comparision between floating exchange rate and fixed (or pegged) exchange rate. A floating exchange rate refers to the situation when the currency's value is allowed to fluctuate according to the foreign exchange market. The value of this currency is determined by the supply and demand shocks in the market of the currency (foreign exchange market). Most of the countries adopting the free floating exchange rate regime (floaters) are developed small open economies, such as Canada, Australia, Sweden. .

The basic debate between fixed and floating exchange rate regimes could go back to most textbooks in principle of macroeconomics, where Mundell–Fleming model is presented to explain the exchange rate regimes. There are trade-offs called “impossible trinity”, a country could not get access to the following three at the same time.


 * fixed exchange rate


 * open to capital flows


 * indepedent central bank and monetary policy

Some economists believe, in most circumstances, floating exchange rates are preferable to fixed exchange rates. Firstly, giving up the fixed exchange rate could gain more flexibility in monetary policy. For some countries, inflation is the main policy target by the central bank, it is often true that a high degree of exchange rate flexibility would help inflation targeting to be more successful. Secondly, as floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis.

In practice, a central bank would not ignore the substantial movements in exchange rate. Most monetary authorities in emerging market economies have two targets, they aim to maintain a low inflation while avoiding large currency movements.

Central banks in emerging economies will usually intervene to stabilize the currency when there is too much fluctuation in a short time period by policy instruments. Thus, the pure floating exchange rate regimes is quite rare in reality, most of floating currencies may be classified as a managed float. However, it still seems puzzling that the extent to which some developing countries control the fluctuation in nominal exchange rates. More possible reasons are required to justify this “fear of floating” phenomenon.

Empirical evidence
Some countries announced intentions to float, but they still try to keep the volatility of exchange rate as small as possible.

The Philippines announced it would float on January 1988, yet until 1997 currency crises, its exchange rate policy switched to “soft peg”.

Bolivia announced it would freely float on September 1985, but actually the exchange rate is so closely tracked the US dollar that the regime was reclassified as a managed float.

In recent Asian market, although Korea and Thailand adopt the new floating regime, they seem to accumulate foreign reserves by intervention in the foreign market. This could be regarded as precautionary building a “war chest” of international reserves to avoid similar financial crisis as 1997-98 crisis in the future.

Some explanations
Why a country might prefer a smooth exchange rate with low volatility and be reluctant to float the currency? A free floating exchange rate would increase foreign exchange volatility, it might be very large during crisis period. This could cause serious problems, especially in emerging economies.

liability dollarization
Firstly, liability dollarization is one main reason against floating exchange rate. There is an output cost associated with exchange rate fluctuations. This output cost produces a fear of floating. (see the model in Lahiri and Vegh, 2001 ) When liabilities are denominated in foreign currencies (usually denominated in US dollar) while assets are in the local currency, unexpected depreciation of local currency would deteriorate bank and corporation's balance sheets, they have to pay more in terms of domestic currency or commodities to clear the foreign debt, and the shrink in asset relative to foreign currency liabilities would threaten the stability of the financial system in local country.

lack of credibility and inflation targeting
Another main reason for fear of floating arises from the combination of lack of credibility, a high pass-through from exchange rates to prices and inflation targeting. This is also motivated by the fact that there is trend in emerging markets to couple floating with explicit inflation target. Calvo and Reinhart (2002) present a simple model to show “fear of floating” is attributed to lack of credibility and inflation targeting.

Implication in favor of monetary union
Within one monetary union (e.g Euro zone), countries share a single currency or exchange rate is fixed. So the previous reasons for fears of floating might make the idea of common currency area more alluring to the would-be entrants of euro zone.

For these countries in Europe, since there is long border, heavy trade and industry links with the euro zone, it is extremely difficult to control the capital flows. For these economies to have an independent monetary policy, it had to let its currency to float against the main currencies in the world. In principle, floating exchange rate adjusts automatically to keep economy in balance, but in real practice, these fluctuations would possibly veer wildly from the ideal level. These variations of exchange rate can be a source of instability.

For the countries who recently joined euro zone, most of them are samll and very open economies. The export accounts for a significant share of the GDP and international trade, especially the trade with EU countries play an essential role. As emerging countries, when the currency value becomes volatile they are prone to the sudden shift of investments and capital flows (perhaps by foreign investor animal spirits and this is similar to sudden stops in Latin American countries).

The exchange rate stability is quite attractive for these emerging countries, in this trade-off between exchange rate stability and monetary independence, the former would dominate since there is less scope to manage domestic prices through an independent monetary policy relative to a closed economy and a large country.