Band, basket, and crawl (BBC)
BBC (basket, band, and crawl) constitute the three pillars of an intermediate exchange-rate regime. A currency that uses all three pillars has its central rate (and margins) defined in terms of a basket of currencies rather than a single currency such as the dollar. It has a wide band around the central rate, perhaps plus or minus 5, 10, or 15 percent, within which the currency floats, but at the edge ofwhich the central bank is obligated to intervene to prevent the market rate going outside the band. Its central rate crawls rather than jumps; when it needs to move, it does so in a series of small, periodic steps rather than occasional abrupt changes. The three component elementswere developed by different economists and were driven by different considerations, so they can be analyzed separately even though they tend to appeal to the same group of economists and to be used by the same set of countries. Although in practice there may be a strong complementarity among the three components, it is possible and helpful to consider them separately.
Before the break-up of the Bretton Woods systemin the early 1970s therewasno need to consider pegging to a basket of currencies since the major currencies were stable in relation to one another. It became clear that this was not going to continue after the advent of generalized floating in March 1973. Shortly thereafter the International Monetary Fund (IMF) redefined the value of its artificial reserve asset, the special drawing right (SDR), in terms of a basket of the 16 currencies of countries withmore than 1 percent ofworld exports in the base period.When Jordan began to peg to the SDR, itwas therefore indirectly pegging to a basket of currencies. This was the first instance of a peg to a basket.
The theoretical basis of the basket peg evolved shortly thereafter, in a number of papers that sought to develop rules for howdeveloping countries should conduct their exchange-rate policies in aworldwhere the major currencies were floating and therefore moving randomly against one another. The first major paper along these lines was that of Stanley Black (1976). He argued that in a context of generalized floating the strategic variable that affected a country’s macroeconomic position was not its bilateral exchange rate with any single currency, but its effective (i.e., trade-weighted) exchange rate. According to Black, the weights in the effective exchange rate (EER) should reflect trade, both exports and imports, in goods and services in other words, the EER should be a concept broader than just commodity trade but narrower than all transactions that go through the foreign exchangemarket, in that it should not include capital flows. He also discussed whether the weights should reflect the currency of denomination or the direction of trade, preferring the latter on the ground that thiswasmore relevant in the longer run. He recognized that there would be institutional costs in pegging to a basket, stemming fromthe fact that one could not intervene in a basket. (One can argue that the main cost of pegging to a basket accrues not as Black assumed because of the enhanced calculation costs of the monetary authority, but because it deprives traders of the possibility under normal circumstances of covering forward by utilizing the forward markets of the country’s intervention currency.) If, but only if, a country decided that those institutional costs outweighed themacroeconomic benefits of pegging to a basket, then a country should peg to that single currency which minimizes the variance of its EER.
Several subsequent writers entered the debate. The possibility of a number of developing countries all pegging to the SDR was considered, the advantage being that this would avoid arbitrary changes in their cross-rates. Williamson (1982) argued that there was widespread agreement among the authors surveyed in the article that the peg should be chosen with a view to stabilizing something rather than optimizing anything. Specifically, the peg should be picked so as to minimize the instability in real income and inflation imposed by movements in third currencies that are noise to the domestic economy. This is the philosophy that lies behind the first B of BBC. It is perhaps best exemplified by the policy pursued for many years by theMonetary Authority of Singapore.
In recent years proposals for basket pegs have been advanced primarily in the context of East Asia. Several writers (e.g., Williamson 2005) have argued that the motivation to tie the region’s currencies to the dollar arises not out of amercantilist desire for export surpluses but as a response to the fear of losing competitiveness vis-a`-vis one another. The way to overcome this collective action problem while avoiding wasting resources on large current account surpluses as a by-product of dollar depreciation is for all the countries of the region to use a common basket peg.(Inthecaseoffloatingcurrencies,countriesmight treat the common basket as a nume´raire, the unit in terms of which the value of the currency is defined, though this gives less assurance that the market exchange rate would move in parallel to the basket.)
Discussion of a wide band for the exchange rate (then called awidening of the gold points) can be traced back to some of John Maynard Keynes’s writings in the interwar period, but in the postwar period it was revived by a Brookings Institution report (Salant et al. 1963) and an influential paper of George Halm (1965). Halm looked to a wide band with permanently fixed central rates to enable exchange rate movements to make a worthwhile contribution to the adjustment of balance of payments positions, while decreasing the need for identical monetary policies in different countries and therefore increasing the ability of monetary policy to achieve internal balance. It was this latter aspect on which most subsequent attention focused.
Later authors have differed sharply from Halmin viewing a wide band as complementary to, rather than competitivewith, a crawl of the central rate.Few recent analysts have agreed with himin thinking that variations in the exchange rate within the band could be expected to make a worthwhile contribution to payments adjustment; it is changes in the central rate that were expected to do the heavy lifting in that regard. However, the freedom to vary monetary policy has been emphasized by many writers (McKinnon 1971). Williamson (2000) emphasized that this is one of four reasons for favoring a wide zone. A second reason is the difficulty in identifying the equilibrium exchange rate (a rate that is usually conceived as consistent with a sustainable balance of payments outcome) with any precision; there is no point in distortingmacroeconomic policy in order to defend an exchange rate target if there is a chance that the rate is not misaligned in the first place. A third reason for a wide zone is to permit nontraumatic changes in the central rate. The analysis here goes back to Harry Johnson (1970), who showed that therewould be no incentive to speculate if the change in the central ratewere sufficiently small that the new and old bands overlapped; the wider the band, the easier it is to satisfy this condition. The fourth reason is the desirability of being able to accommodate strong capital flows in part by changes in the exchange rate rather than compelling them to be met entirely by reserve changes.
In 1988 Paul Krugman showed that a credible band would help the authorities to enlist support fromspeculators in stabilizing the exchange rate (the definitive version was published as Krugman 1991). The intuitive argument was that as the exchange rate approached the margin, speculators would understand that it was increasingly likely to move back toward the central rate, because if it tried to move beyond the edge of the band this would merely provoke the central bank into intervention rather than lead to a further change in the rate. Speculators would therefore be induced to enter the market and help stabilize the rate. The mere promise of official intervention at the margin would suffice to stabilize the rate, without any need for the central bank to actually intervene. First tests of the experience of the European Exchange Rate Mechanism (ERM) were reassuring: it did indeed seem that expectations within the ERMwere mean-reverting, in contrast to those that hold in a floating system. But further tests created doubts: Krugman’s model predicted that exchange rates would spend most of their time close to the edges of the band, but this did not seemto have happened in the ERM (Svensson 1992). One could reconcile the findings, for example, by intramarginal intervention, but that cast doubt on whether the target zone was really fulfilling its key purpose of making expectations stabilizing. And the ERM was not altogether credible, as is required for Krugman’s theorem to apply.
A central rate is said to be adjusted according to a crawl if its changes are ‘‘small.’’ Just how small is best answered by the Johnson analysis cited earlier: a rate is crawling if the old band (prior to the change in central rate) overlaps with the new band. By that test one would count the pre-1987 ERM central rates asmostly crawling, since, although there was no legal obligation for the bands to overlap, in practice changes in the central rate were usually small enough to produce such an overlap.
A crawl may have several motivations. Probably the principal aim in practice has been to neutralize differential inflation and prevent a country that is inflating faster than the international norm from eroding its competitiveness. This is what led several Latin American countries (first Chile in 1965, then Colombia in 1967, and Brazil in 1968) to institute a crawl in the 1960s. Nowadays we tend to think that there is notmuch to be gained by running a high rate of inflation, but countries caught up in high inflation found difficulty in reducing it quickly and were acutely interested in preventing it fromundermining their trade performance.
A much less common but surely more constructive purpose has been to neutralize biased productivity growth, for example, the bias in favor of tradables that typically comes as a by-product of rapid productivity growth (the so-called Balassa-Samuelson effect). Chile’s crawl allowed 2 percent a year in real appreciation for this effect from 1995 until Chile floated in 1998.
Changes in the central ratemay also bemotivated by the desire to contribute to balance of payments adjustment. A country that wishes to improve its underlying balance of payments position will usually be advised to seek a more competitive exchange rate asone incentive for adjustment.Unless a government chooses to float its currency, it will have to accept a gradual adjustment, so that the incentive for capital flows can be offset by the interest differential. It was the desire to maintain a reasonable balance in international payments thatmotivated most of the parity adjustments in the early-phase ERM.
Why a BBC System?
Perhaps the most basic argument in favor of the BBC regime is that this is the system best calculated to limit misalignments (defined as deviations of the market exchange rate from its equilibriumvalue), and thatmisalignments are the principal drawback of both of the alternative regimes. Fixed rates can become inappropriate through differential inflation, Balassa-Samuelson productivity bias, or a real shock that creates a need for balance of payments adjustment. Fixed rates are appropriate only where there is reasonable certainty that none of these dangers will materialize: where the economy is small and open so as to satisfy the optimumcurrency area conditions; where it trades predominantly with the currency area to which it plans to peg; where it is comfortablewith the inflation policy of that area; and where it is content to adopt institutional arrangements that will guarantee perpetuation of the fixed rate. Flexible rates follow a random walk: they are frequently pushed away from the level that would support a satisfactory evolution of the real economy. A BBC regime provides guidance as to what is considered the longer-run equilibrium rate and mandates action to bring the rate back to that vicinity when it deviates significantly from it. It is true that one advantage of a float, in comparison to the BBC regime, is that this permits a needed adjustment to be made instantaneously, rather than being strung out over time, with the need to retain an offsetting interest differential. There is no guarantee, however, that the private market will choose to make an adjustment at the right time or in the right direction. It is this fear that unguided markets will lead to misalignments that motivates support for the BBC regime. See also balance of payments; Balassa-Samuelson effect; Bretton Woods system; effective exchange rate; equilibriumexchangerate; exchangerate regimes; exchangerate volatility; hedging; special drawing rights; speculation