Back Matter

Back Matter

Inci Ötker
Published Date:
April 2007
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    Appendix I From Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates

    This appendix summarizes the main points of the IMF’s operational framework for moving toward flexibility for those countries that have decided to move to a more market-determined exchange rate.1 This framework provides hands-on guidance on the institutional, operational, and technical aspects of moving toward exchange rate flexibility, drawing on the experience of countries that have managed the transition.

    Operational Ingredients of Durable Exits from Fixed to Floating Regimes

    Although the timing and priority accorded to each of these areas may vary from country to country depending on initial conditions and economic structure, the successful ingredients for floating include:2

    • Developing a deep and liquid foreign exchange (FX) market;

    • Formulating intervention policies consistent with the new exchange rate regime;

    • Establishing an alternative nominal anchor in the context of a new monetary policy framework and developing supportive markets; and

    • Reviewing exchange rate exposures and building the capacity of market participants, including the public sector, to manage exchange rate risks and of the supervisory authorities to regulate and monitor them.

    Developing a Deep and Liquid FX Market

    Operating a flexible exchange rate regime works well only when there is a sufficiently liquid and efficient FX market for price discovery.3 A well-functioning FX market allows the exchange rate to respond to market forces and helps to minimize instances and durations of disruptive day-to-day fluctuations in the exchange rate and longer-term deviations from equilibrium. Fixing the exchange rate itself is often a key factor in limiting FX market liquidity. A central bank operating a fixed exchange rate regime is usually active in the market by necessity, which reduces the need for market participants to trade and keeps them from gaining experience in price formation or exchange rate risk management. In the extreme, the central bank may dominate the interbank FX market and act as the primary FX intermediary.

    Allowing some exchange rate flexibility is a key step that can help improve the depth and efficiency of the FX market and stimulate better risk management. Such flexibility, in turn, could limit what is, to some extent, an unavoidable chicken-and-egg problem: Exchange rate flexibility requires a deep market and better risk management, but a deep market and prudent risk management require flexibility. Fluctuations in the exchange rate, even if small, quickly create incentives for market participants to gather information, form views, price foreign exchange, and manage exchange rate risks. Creating a sense of two-way risk in the exchange rate is also essential in establishing a deep market and capacity to manage risks. Market perceptions that the exchange rate can either appreciate or depreciate help reduce the risk of one-way bets against the central bank, minimize destabilizing trading strategies, and help foster better risk management expertise.

    There are four key aspects of deepening the market and enhancing price discovery: (1) reducing the central bank’s market-making role, including its quotation of buying and selling rates, and requiring market makers to provide two-way price quotations; (2) increasing market information and transparency on the sources and uses of foreign exchange, detailed economic data, and a coherent policy framework as a basis for market participants to develop accurate views on monetary and exchange rate policy and efficiently price foreign exchange; (3) eliminating (or phasing out) regulations that stifle market activity;4 and (4) improving the market’s microstructure, including by reducing market segmentation, improving the effectiveness of market intermediaries, and securing reliable and efficient settlement systems.

    A Coherent FX Intervention Strategy

    FX market intervention becomes discretionary under a flexible exchange rate regime, making it essential to establish well-specified intervention principles to enhance credibility of the new regime. The authorities face some difficult dilemmas and need to consider a number of important issues in this process:

    • Potential disconnect between the exchange rate and macroeconomic fundamentals can create a role for intervention under floating exchange rates, even in well-functioning FX markets. But misalignments are difficult to detect and the typical indicators may not always allow policymakers to identify the degree of misalignment precisely enough to pinpoint appropriate intervention amounts and timing.5

    • Volatility reflecting market illiquidity may warrant intervention, because the latter stifles trading and, if it persists, can have serious adverse effects. Intervention can jump-start the market or tip a perverse price trend in the other direction. However, short-term volatility may not always warrant intervention, especially when it occurs in an orderly (liquid) market. Volatility often reflects the process of price discovery and provides useful signals to policymakers and the market. Efforts to smooth such volatility often end up suppressing useful signals and reduce incentives to learn how to manage FX risks.

    • Exercising restraint in intervention during the transition to a flexible regime can help signal the official commitment to a market-determined exchange rate. Interventions that target an exchange rate level or a path can undermine the credibility of the new regime. By entering the market infrequently, central banks can maximize the element of surprise and the chances of intervention effectiveness and can build market confidence in the commitment to flexibility. As confidence grows, policy pronouncements and the capacity to intervene may suffice in most instances to achieve the desired change in the price trend, without an actual intervention operation.

    • Even in fully flexible exchange rate regimes, central banks cannot completely avoid regular interventions (for example, to have a regular FX supply from purchases of the foreign currency revenue of public sector companies or export boards, or to target an appropriate level of reserves). Such interventions can be regular, preannounced, and rule-based (for example, through auctions) to support the information flow to the market, reduce noise, and enhance the signaling of surprise interventions.

    The transition to flexible exchange rates hence creates the need to develop a coherent intervention strategy that specifies the policies on objectives, timing, and amounts of intervention. Whether the objective of intervention is to correct misalignments, calm disorderly market conditions, accumulate reserves, or supply publicly acquired foreign exchange to the market, care needs to be taken to signal the commitment to a market-determined rate and avoid excessive smoothing of short-term fluctuations. The latter is necessary to avoid suppressing the nascent markets and the useful market signals, as well as to avoid sending confusing messages about policy intentions. Intervention policy transparency is important in building confidence in the new regime, especially following forced exits. A public commitment to both the objectives of intervention and the criteria applied in its conduct enables market scrutiny and accountability for the central bank’s FX operations.

    Developing an Alternative Nominal Anchor under a New Monetary Policy Framework

    Moving away from a fixed exchange rate creates the need to replace it with another credible nominal anchor and to redesign the monetary policy framework around the new anchor. The two tasks, in turn, require a substantial amount of capacity building and credibility building, and thus planning ahead for the transition is critical to achieving an orderly exit. The viability of maintaining a flexible regime without a nominal anchor depends on the authorities’ credibility to sustain a responsible monetary policy without an anchor. Such credibility is generally difficult to build quickly, especially if a country had relied on a rigid exchange rate until the exit. Many countries moving to flexibility in recent years have favored IT frameworks over money-targeting ones (IMF, 2000a; and Khan, 2003). Although the latter can serve as a nominal anchor after floating, the weak relationship between monetary aggregates and inflation limits the effectiveness of such targets.

    However, a credible alternative such as IT requires extensive preparation. A lengthy transition period reflects, in part, the time required to fulfill the necessary institutional requirements and macroeconomic conditions including (1) a central bank mandate to pursue an explicit, publicly announced inflation target as the overriding objective of monetary policy; (2) central bank operational independence; (3) transparency and accountability in the conduct and evaluation of monetary policy actions; (4) a reliable methodology for forecasting inflation and its link with other macroeconomic aggregates; (5) a forward-looking operating procedure that systematically incorporates forecasts into policy actions and responds to deviations from targets; (6) lack of fiscal dominance; and (7) a well-regulated and supervised financial sector (see Carare and others, 2002; Eichengreen and others, 1999; Fraga, Goldfajn, and Minella, 2003; IMF, 2000a and 2000b; and Mishkin, 2000).

    The difficulty of developing a credible alternative nominal anchor to the exchange rate has also caused many countries to relinquish its anchor role only gradually or follow various versions of the monetary-targeting approach. Especially in the case of disorderly exits, some countries adopted monetary targets (namely, targeting base money, broad monetary aggregates, or bank reserves) in an effort to quickly establish a new nominal anchor and restore policy credibility until the preconditions of IT were established. Some countries used crawling bands as an intermediate regime for transitioning to another nominal anchor over a long period. The band usually has been set symmetrically around a crawling central parity and gradually widened over time as the tension between the exchange rate and the inflation rate objectives was eventually resolved in favor of the latter.

    Capacity to Assess and Manage FX Risks

    Private sector FX risk exposures can have an important bearing on the pace of exit, the type of flexible exchange rate regime adopted, and official intervention policies. Floating the exchange rate moves exchange rate exposure from the public to private sector balance sheets, as central banks no longer stand ready to intervene at fixed rates (Allen and others, 2002).6 Determining the scale and scope of FX risk exposures in the financial and nonfinancial sectors is therefore a key area for countries planning an orderly exit from pegs. Early analysis of, and improvements in, the management of FX risk are particularly important in economies where dollarization and currency mismatches are high. Even when these risks are modest early on, market participants need to develop the capacity to measure and monitor them to avoid building up exposures over time.

    Evaluating exchange rate risk exposures involves detailed balance sheet analysis—focusing on the currency composition of balance sheets and the maturity, liquidity, and quality of foreign currency assets and liabilities. Unhedged FX borrowing by the corporate sector can translate into massive losses for banks and a surge in demand for foreign currency. Banks often closely control foreign currency liabilities and assets, but even when these are matched, the use of short-term foreign currency funds to finance long-term FX loans to unhedged borrowers causes their FX risks to translate into sizable credit and liquidity risks for banks (indirect FX risks). Two related risks also require close attention: (1) maturity mismatches in bank’s foreign currency books that expose them to foreign currency liquidity risks and (2) corporate and banking sector exposure to interest rate risk that can limit the extent to which the central bank can use interest rates instead of interventions in the FX market. Corporations in developing countries have particular difficulty off-loading interest rate risk, particularly because they may not be able to obtain long-term fixed rates for their liabilities to fund assets.

    An orderly exit from a pegged regime hence requires close scrutiny of the private sector’s capacity to manage FX risk. Market participants need to develop information systems monitoring the FX risks, analytical systems for risk measurement, and internal risk and prudential procedures. Adequate prudential and supervisory arrangements need to complement internal risk management systems. Prudential measures may include limits on net open positions (as a percentage of capital), foreign currency lending (as a percentage of foreign currency liabilities), and overseas borrowing and bond issuance (as a percentage of capital); limits on the range of FX operations banks are allowed to perform; capital requirements against FX lending or risk;7 and the issuance of regulations or guidelines on the design of bank’s internal control systems. Improving the capacity to enforce regulations can help ensure that regulations are complied with and are effective. Developing a risk-based supervisory system can help ensure that the internal control systems are adequate and properly enforced.

    Although early investment into these elements is typically beneficial on its own, it can also help in mitigating the risk of disorderly exits during market turbulences. For instance, providing for a two-way risk when developing FX markets reduces the scope for destabilizing risk strategies. Similarly, having an effective FX-risk-related supervisory and prudential framework can prevent contagion of financial crises.

    Carefully developed derivatives markets for foreign exchange are an essential element in building capacity to manage FX risks. However, facilitating the development of risk-hedging instruments by lifting controls on forward market activity can be a double-edged sword. While improving risk management capacity and supporting FX market development, liberalization of forward transactions could also facilitate speculative activity where there are incentives to do so. Several considerations can help guide the safe use of derivatives. Such instruments require financial institutions (and corporations) that have achieved a certain level of sophistication in risk management and supervisory authorities capable of conducting risk-based supervision. Close monitoring of the use of the instruments is important to prevent their being used to push a normally sustainable situation over the edge by sizable leveraged bets. Also critical are the standardization of derivative products traded among banks and the presence of accounting standards for fair valuation and a reliable legal system for contract enforcement. The central bank should promote market transparency and, with other regulators, promote high reporting standards.

    Pace and Sequencing of Exit to Exchange Rate Flexibility

    There are important policy questions regarding the pace of exit and sequencing of moves toward exchange rate flexibility with other policies, including capital account liberalization. These questions involve difficult trade-offs and considerations that are often country-specific, including the degree of preparedness for floating rates, the openness of the capital account, the macroeconomic situation, and the condition in the domestic and international markets. Some broad conclusions are as follows:

    • If taken from a position of macroeconomic strength, a faster pace of exit has benefits in that it signals purpose and determination, thereby enhancing the credibility of monetary policy. It also has a greater chance of exploiting what may turn out to be a narrow window of tranquility, provided also that the institutional underpinnings for operating a floating exchange rate are in place.

    • In practice, the pace at which relevant institutions (for example, an alternative nominal anchor and the capacity to manage risks) can be built is a main determinant of the pace at which an orderly exit can proceed. Many countries have opted for a gradual approach, which in principle may reduce the risk of excessive exchange rate volatility and its potentially adverse effects on inflationary expectations. It also allows the FX market to deepen through the mutually reinforcing relationship between FX activity and exchange rate flexibility and provides time to build the remaining institutional blocks.

    • Early preparation for an exchange rate float can bolster the chances of success of the exit strategy—gradual or rapid. Many of the operational areas require substantial information on the exposures to and capacity to manage FX risk, and increasing data on balance of payments developments. These steps can be undertaken early on, even before a peg is exited. The second stage may involve allowing some exchange rate flexibility to stimulate FX market activity and continuing to develop other operational areas. Intervention policies can be addressed at a relatively later stage, once greater exchange rate flexibility is embraced (see Appendix Figure A1 for a suggestive illustration of the various stages taken toward moving to full flexibility).

    • The absence of a full-fledged IT framework as an alternative nominal anchor should not preclude a rapid exit strategy, provided that there is a robust commitment to price stability. The building blocks of IT—such as fiscal discipline, operational independence of the monetary authorities to pursue low inflation, and transparency and accountability—are necessary for the success of any monetary policy regime regardless of a formal adoption of IT.

    • The pace of exit also needs to take into account the openness of the capital account. For example, it may be difficult to pursue a gradual exit strategy under conditions characterized by large and volatile capital flows. By contrast, a less open capital account would make it easier to operate variants of pegs or manage the exchange rate within a band. Clear trade-offs are involved in the sequencing of exchange rate flexibility and capital account liberalization.8

    • There are risks to opening the capital account before adopting a flexible exchange rate; many countries were forced off pegs after sudden reversals of capital flows, whereas others faced heavy inflows and appreciation pressures and had to allow flexibility to avoid overheating. On the other hand, liberalizing the capital account can help offset transitory current account shocks, expand the instruments for risk management, and deepen the FX market, which is important for operating a flexible exchange rate.

    • The transition to flexibility can be facilitated by removing or strengthening existing asymmetries in the openness of the capital account to support an orderly correction of misalignments (for example, by liberalizing outflows to reduce pressures from inflows, and liberalizing long-term inflows before short-term ones). Remaining controls can be removed following a successful move to floating.

    Figure A1.Preparing for an Orderly Exit from a Peg

    Source: IMF (2004a).

    This summary, prepared by Neil Saker, draws on IMF (2004a and 2004b), which in turn draws heavily on Duttagupta, Fernandez, and Karacadag (2004).

    These are in addition to the role of sound macroeconomic and structural policies—including fiscal discipline, monetary policy credibility, and a sound financial sector—which are essential to maintaining any type of regime, fixed or floating.

    The FX market in general consists of a wholesale interbank market, in which authorized dealers (usually banks and other financial institutions) trade among themselves, and a retail market, in which authorized dealers transact with final customers (usually households and firms). The interbank market is where price discovery occurs through a decentralized allocation of FX by market participants on their own behalf as well as on behalf of their customers. A liquid market is characterized by (1) relatively narrow bid-offer spreads to lower transaction costs (tightness); (2) high turnover in volume as well as an abundance of orders to minimize the price impact of individual trades (depth and breadth); (3) efficient trading, clearing, and settlement systems to facilitate the swift execution of orders (immediacy); and (4) a wide range of active market participants to ensure that new orders flow quickly to correct order imbalances and misalignments (resiliency) (see Sarr and Lybek, 2002).

    These regulations include, for example, (1) abolishing surrender requirements for FX receipts to the central bank, taxes and surcharges on FX transactions, restrictions on interbank trading (for example, outright bans on interbank trading or a requirement that all spot and forward market trades with customers have an underlying commercial transaction), and limits on price ranges quoted by dealers; (2) unifying segmented FX markets; and (3) relaxing current and, to some extent, capital account restrictions to bolster the sources and uses of foreign exchange in the market.

    These indicators include, for example, the nominal and real effective exchange rates, productivity and other competitiveness measures, the terms of trade, the current external account and balance of payments outlook, interest rate differentials, and parallel market exchange rates.

    The public sector remains exposed to risks relating to its foreign-currency-denominated public debt.

    The Basel Committee recommends a capital charge of 8 percent on the open position based on the shorthand method and recommends that the net open position does not exceed 2 percent of capital, although countries with greater risk exposures may need to adopt more conservative limits (Basel Committee on Banking Supervision, 1996). All open position calculations should include net spot and forward positions, guarantees, and net future income and expenses not yet accrued, but already fully hedged.

    The successful liberalization of the capital account itself depends on a wide range of issues related to the economy, financial sector stability and reform, and sequencing issues (see Ishii and others, 2002).

    Appendix II Experiences with Short-Lived Exits to Greater Flexibility1

    The experiences of the countries presented below highlight a number of factors relating to macro conditions, commitment to reform, and operational aspects that have contributed to reversals in the attempts to establish greater exchange rate flexibility. In particular, they highlight the roles of (1) an underdeveloped and illiquid FX market (Uzbekistan), (2) a limited capacity to manage exchange rate risk with ensuing fear of floating (all three cases), (3) a lack of an appropriate (for example, rules-based) intervention policy (Uzbekistan and Pakistan), (4) a limited institutional and technical capacity to adopt a credible alternative nominal anchor (Uzbekistan and Pakistan), (5) a limited degree of monetary policy independence (Ecuador and Uzbekistan), (6) adverse economic conditions and poor macroeconomic policy (Ecuador), and (7) a lack of commitment to free (exchange) markets (Pakistan and Uzbekistan).


    In February 1999, the Ecuadorian authorities abandoned the exchange rate band and moved to a floating exchange rate regime after repeated episodes of exchange market pressures. The Ecuadorian economy plunged into a major economic crisis in 1999: Real GDP declined by about 7.5 percent; inflation accelerated to 61 percent; the fiscal deficit exceeded 5 percent of GDP; public debt grew to over 100 percent of GDP and was in default; unemployment almost doubled to 17 percent; FX reserves fell by 64 percent; and volatility of the sucre continued well after the floating, depreciating by 200 percent in 1999.

    Simultaneously Ecuador was hit by a major crisis in the banking sector. The crisis originated in persistent institutional weaknesses in banking supervision and regulation that allowed excessive accumulation of credit risk from connected and foreign currency lending to unhedged borrowers. The weaknesses in the banking system were exacerbated by a tradition of bailing out troubled banks. Lack of effective supervision of offshore subsidiaries of banks provided an easy way to circumvent regulations and controls and ultimately contributed substantially to the losses of failed banks.

    The banking crisis further weakened monetary and exchange rate policy, which resulted in renewed exchange market pressure at the end of 1999. With shattered monetary policy credibility, looming hyperinflation, and no access to international financial markets after the sovereign default on the Brady bonds in the fall of 1999, the authorities moved to a full-blown dollarization in January 2000.


    Pakistan made two attempts to introduce greater exchange rate flexibility from a de facto peg to the U.S. dollar. The first move took place during 1998, when a number of liberalization measures were undertaken (based on the recommendations of an IMF mission in 1997) to allow greater scope for market determination of the exchange rate. The process was interrupted in May and June 1998 with the introduction of exchange controls and a dual exchange system. In May 1999 the exchange rate system was unified and an initial attempt was made at liberalizing the exchange rate by allowing authorized dealers to quote their own buying and selling rates.

    However, the authorities reversed some of the liberalization measures. Only a month later, they imposed a narrow exchange rate band. In May 2000, they made a new attempt at liberalizing the exchange rate and invited an IMF mission to advise on a framework for money and FX market operations. However, the authorities continued their strong preference for maintaining nominal exchange rate stability through (1) direct and indirect interventions on the official and parallel markets, (2) exertion of moral suasion on market participants, (3) close monitoring of bank’s activity, (4) imposition of restrictions on authorized dealers’ FX operations, and (5) other indirect forms of intervention (for example, managing import demand). All these restrictive measures hampered the interplay of demand and supply in the FX market and did not allow an exchange rate adjustment as warranted by the underlying macroeconomic conditions.

    Pakistan’s slow progress toward greater flexibility suggests a lack of operational preparedness. The FX market is not sufficiently liquid; the intervention policy has not been developed to yield consistent and transparent outcomes; formal adoption of IT is still in process; and the institutional capacity to manage exchange rate risk is not fully developed.


    In July 2001, the authorities took steps toward greater exchange rate flexibility motivated primarily by a consideration to implement economic reforms. An over-the-counter market was created for buying and selling foreign exchange to allow the exchange rate to float freely in accordance with demand and supply, but the market remained shallow. Progress toward a market economy was slowing because of excessive government control, including (1) restrictions on domestic and external trade, (2) numerous barriers to the normal functioning of the financial markets, and (3) exchange restrictions and controls (including surrender requirements and restrictions on interbank sales of foreign exchange).

    The financial sector remained weak with substantial vulnerabilities related to FX risk. Uzbekistan’s banking system was characterized by extensive government controls and limited confidence in financial intermediation. In addition, banks had large exposures to FX risk. Uzbek banks were heavily dependent on foreign financing, and a reduction in the flows of such financing would jeopardize their ability to continue to finance the domestic economy.

    A fear of floating led to frequent intervention in the FX market and to a reversal to a more tightly managed exchange rate regime. The fear of floating stemmed from a number of factors, including a strong pass-through from the exchange rate to inflation, the potential impact of the high level of liability dollarization on private sector balance sheets, potential output costs of variable exchange rates, and concerns about the implications for the heavy dependence of Uzbek banks on external borrowing.

    Prepared by Jahanara Zaman.

    Appendix III Ukraine: An Example of Ongoing Cautious Steps toward Greater Exchange Rate Flexibility1

    Ukraine’s move toward exchange rate flexibility is motivated by the difficulties in maintaining a fixed exchange rate with an increasingly more open capital account and a surge in foreign exchange receipts from the large current account surplus. Since 1999 the authorities have maintained a de facto peg to the U.S. dollar, but over time the balance of payments situation has changed from being at the brink of default to a sizable current account surplus (though more recently, the current account balance switched from a large surplus to a deficit). Short-term capital inflows attracted by the perception of exchange rate undervaluation added to the pressure on the hryvnia in 2005 and complicated the control over monetary aggregates and inflation.

    In response to these developments, the authorities took a number of actions in 2005. They increased sterilization operations and prohibited nonresident purchases of short-term treasury bills. They have also taken some initial steps to increase exchange rate flexibility by allowing a step appreciation of the hryvnia and introducing an indicative narrow band of HRV1/US$5.0-$5.2; the official exchange rate has been left unchanged at HRV1/ US$5.05, however, and the interbank market rate has mostly moved in a narrower band of HRV1/US$5.00-$5.06. Furthermore, since late 2004 the authorities have been focusing on preparations for the introduction of an IT regime as an alternative nominal anchor.

    The authorities’ approach to moving toward greater exchange rate flexibility has been very cautious, reflecting a number of challenges typically associated with fear of floating: concerns about losing a transparent nominal anchor and policy credibility, potential exchange rate losses associated with currency mismatches in corporate balance sheets, weaknesses in bank’s risk management practices and lack of hedging markets and instruments to cover against exchange rate risks, underdeveloped financial markets, and fears of worsening of external competitiveness should the currency appreciate.

    Some progress has been made in most of the areas identified in the fixed-to-float framework and technical assistance (TA) reviews, but further efforts are needed.2 First, with a view to establishing the elements of an inflation-targeting framework, the National Bank of Ukraine (NBU) has started improving its modeling and forecasting capacity over the past two years, communicating more on the introduction of IT, and improving monetary policy transparency. Further efforts are needed to firmly establish NBU’s operational independence, clarify the primacy of price stability as the main monetary policy objective, continue efforts to strengthen the communication strategy, and deepen financial markets and instruments. The efforts to accelerate the preparations have been undermined by an uncertain political environment.

    Second, the spot and forward foreign exchange markets remain substantially underdeveloped and illiquid. A high degree of regulation and dominant central bank presence in the market have been key obstacles to market development. To address these issues, the NBU undertook measures in 2005 to relax restrictions on forward transactions, on open foreign exchange positions, and on bank’s two-way trading and to make foreign exchange trading more flexible and transparent. These measures have not yet become productive, reflecting in part the existence of a fee on foreign exchange transactions and the absence of liquid interbank and government securities markets to facilitate price formation in the forward market.

    Third, banks and borrowers continue to remain vulnerable to foreign exchange and related risks. Existing limits on short positions seem to be binding, but in practice the banks tend to balance their foreign exchange liabilities with foreign exchange credits, extending them even to clients with no foreign currency earnings; foreign-currency-denominated lending has been about 40 percent of total loans since 2001 and has edged up recently to over 40 percent. The NBU tightened supervision and regulation of banks, and introduced higher provisioning requirements for foreign exchange lending to unhedged borrowers to address indirect foreign exchange risks. However, banks also face maturity risks, with maturities of bank funding not having kept up with the increase in loan maturities. A potential funding risk for banks also emerged, because the rising dollarization of loans has required banks to borrow foreign funds, making banks vulnerable to rollover and liquidity risks.

    Finally, lack of adequate capacity to affect market interest rates hinders the introduction of IT as well as the capacity to implement a flexible exchange rate regime. Although the central bank has several instruments to steer market liquidity, it lacks a transparent policy rate to influence short-term interest rates. The discount rate, the NBU’s policy rate, has no influence on interest rates, and the refinancing rate has lost its signaling function. Reserve requirements have played an increasingly large role in steering liquidity, not least because of lower fiscal costs compared with other sterilization instruments, but have caused significant interest rate volatility, raised spreads between borrowing and lending rates, and led to concerns about their implications for financial intermediation. The NBU has recently increased its focus in this area to improve the functioning of its monetary instruments.

    Prepared by Inci Ötker-Robe and David Vávra.

    To support the transition, the authorities have received extensive technical assistance from the IMF since late 2004 in the areas of moving to greater exchange rate flexibility; monetary operations; monetary policy communication; bank supervision, regulation, and resolution; development of the government securities market; and establishing the remaining conditions conducive to adopting an IT regime that could replace the exchange rate anchor.

    Appendix IV Foreign Exchange Hedging, Complementary Markets, and the Role of the Central Bank1

    Foreign exchange risk is present in any modern economy. The risks may not be recognized or transparent, they might be ignored or implicitly transferred or assumed by official entities, or they may be measured and managed. Financial theory as well as extensive experience strongly suggests that failure to explicitly measure and manage risk by the entities that create that risk is potentially destabilizing, at both the institutional and systemic levels. Moreover, FX markets are only one of many financial system components, which are becoming increasingly integrated in developed economies. For reasons of appropriate risk management as well as efficient functioning of the financial system, development of the FX markets requires well-developed hedging and complementary markets.


    Open or unhedged FX exposures pose significant risks and can cause significant losses or even insolvency. The losses can often spread beyond those directly affected to their creditors, especially financial intermediaries, including commercial banks. If severe and widespread, the losses can pose systemic risks to the financial system.

    Hedging FX exposures obviously reduces risk to the individual institution, but also has several other important benefits. It makes risks explicit, which allows them to be better measured, priced, and managed. It also allows the trading and transfer of risk, presumably to those better able to manage it. This improved allocation of risk in the economy should improve overall stability and yield important welfare benefits.

    The central bank can play a key role in stimulating FX hedging. It can make clear the need for hedging; it can help assure that the means of hedging are available; and it can promote the effectiveness of hedging and reduce its cost. The central bank should ensure that the environment and conditions permit and are supportive of hedging; it can also assume an active role in promoting the development of hedging.

    Establishing the need for hedging is best done by making FX risks transparent and making it clear who bears them. Every effort should be made to avoid the creation or appearance of a moral hazard issue, whereby the creators of risk assume that the cost will be borne by others. Specifically, the central bank should eliminate explicit or implicit guarantees, multiple exchange rates, and subsidies. Suppressing volatility of the exchange rate, smoothing operations, or providing a predetermined path of the exchange rate all inhibit management of FX risk, especially when combined with interest rate differentials that are not consistent with the predetermined level or range of the exchange rate. Increased variability of the exchange rate will provide an incentive for hedging practices. The central bank should promote the use of market exchange rates for all transactions, transfer commercial transactions to the market, and reduce the factors that create segmentation among market participants.

    Prudential regulations and supervision should recognize the benefits of financial hedging. Business plans should explicitly address FX exposures, and lenders and financial intermediaries should examine their client’s risk management policies and procedures. Where appropriate, specific regulation might be called for, including higher provisioning requirements on FX loans to borrowers with no FX income, or higher capital requirements against unhedged FX exposures.

    The central bank has an important role in making available the means to hedge FX risks: It should eliminate unnecessary regulatory obstacles that stifle market development. These include surrender requirements, restrictions on instruments such as forwards and options, and restrictions on market participants. For example, restrictions on types of transactions (for example, short selling), or parties to certain transactions (for example, nonresidents prevented from engaging in certain transactions), hinder the development of the market and can introduce serious distortions. The legal framework should be modernized and adapted for modern financial markets, tax issues that increase the cost of hedging should be addressed, and tax discrimination should be eliminated. Accounting standards should provide for appropriate treatment of hedging transactions.

    The central bank can undertake efforts to increase awareness and hedging skills in the relevant sectors of the public, including users as well as third parties, such as accountants and auditors. It can support professional groups (ACI)2 and the setting of standards (CFA),3 as well as market codes of conduct; it can also support the adoption of master agreements and standard documentation of transactions (ISDA4). It could also consider providing support to the market by making available objective benchmarks and pricing mechanisms, such as FX and interest rate fixings. In this case the central bank should play a statistical role only, leaving the market to actually determine the rates.

    Foreign entities can often bring valuable experience and skills in risk management and should be allowed to play a constructive role. Other financial intermediaries, such as nonbank market makers and brokers, can also contribute to market development.

    The effectiveness of hedging depends primarily on the efficiency of the markets and instruments, and the skills of those employing it. Nevertheless, the central bank can also play a useful role. An efficient infrastructure is vital, and payment and clearing systems should meet accepted standards. Safe and efficient payment versus payment and delivery versus payment are essential to a well-functioning financial system, as is the availability of reliable financial data and information. Even where the central bank is not the regulatory authority, a degree of market surveillance can be extremely helpful, especially in the early stages of market development.

    Complementary Financial Markets

    The FX market cannot develop independently of other financial markets. In a modern financial system, markets are highly integrated, information and capital flow quickly, and segmentation is costly and difficult to maintain. Lack of development in one market can retard the development of other markets, introduce inefficiencies and distortions, and hold back positive developments in the economy. Well-developed markets, on the other hand, reinforce one another, promote efficiency, and spur continued development. FX markets are especially dependent on other markets, because FX transactions rarely stand alone: They are often derived from or connected to the need to transact or manage risk in other markets.

    Short-term money markets have the closest link to FX markets because the most basic FX transactions are no more than transfers of bank balances. FX and money market transactions often complement one another, and in some cases can be substitutes. Furthermore, the interest rates established in the money market are vital for developing the FX market, especially that for forward and swap transactions, important hedging tools. A liquid and efficient interbank market in loans and deposits is essential to allow interest rate parity to function.

    Within the FX market itself, foreign exchange versus foreign exchange transactions are important risk management tools (in addition to the FX versus domestic currency transactions that local players will naturally concentrate on). Derivative markets are important adjuncts to the FX market. Forward and swap transactions usually develop in close conjunction with the (spot) FX market and money market, whereas long-dated swaps, futures, and options usually come later.

    Fixed-income markets, especially the government bond market, also play key roles. A liquid government bond market, in addition to its important role in government finance and monetary operations, provides a benchmark to other markets. Absence of a well-developed liquid securities market undermines the market’s ability to price swaps, forwards, and other hedging instruments. A developed capital market complements banking markets, broadens the universe of available assets, diversifies financing channels, and improves operational efficiency.

    The role of the central bank in promoting the development of complementary markets is analogous to its role in developing the hedging market. It can eliminate unnecessary obstacles, such as restrictions on instruments or techniques (such as short sales), and reduce excessive licensing, reporting, or regulatory burdens that stifle market development. It should help establish a strong bank supervisory capability—usually involving coordination with other authorities, including capital market regulators, securities regulators, and organized exchanges—and supervisory authorities of nonbank financial institutions.

    Although it may not be its direct responsibility, the central bank can assist in establishing a conducive environment for market development. The bank can do this by reducing or eliminating institutional segmentation (by product or by customer), clarifying and rationalizing legal issues (such as treatment of collateral and repurchase (repo) transactions), promoting an efficient and transparent tax regime, and eliminating tax discrimination. Clear and modern accounting and reporting standards are also essential. The central bank could also play a supporting role in establishing efficient markets, either organized or over the counter, including brokers and other intermediaries.

    A number of technical issues in the design and function of instruments and markets should also be addressed, because a lack of standards can often constitute a considerable obstacle to the development and acceptance of new instruments and markets. These issues include day-count, computation, and payment methods for money and fixed income markets; information systems; and the availability of indices and reliable benchmarks. Wherever possible, these should be compatible with international standards and accepted market practices.

    Box A1.The Bank of Israel’s Role in Developing Foreign Exchange and Complementary Markets

    The Bank of Israel (BoI) has twice played a direct role in developing markets by issuing derivative financial instruments for the sole purpose of kick-starting financial markets in new instruments. The outcomes were very different, but both illustrate important points.

    The first attempt involved the use of foreign exchange options. All sectors of the economy had extensive experience—not always successful—in dealing with foreign exchange risk. As a result, the use of swaps and forwards, but not options, developed on its own. Moreover, although hedging was widespread in dealing with foreign exchange and foreign exchange exposures, hedging was not widely practiced in dealing with fluctuations of the domestic currency (the new Israeli sheqel—NIS). In part, lack of this sort of hedging stemmed from a long history of managed exchange rates. Managed exchange rates led to a perception that exchange rate risk was a matter for the authorities—the central bank and government—rather than market participants. Available hedging instruments were lacking, and there were indications that this situation stemmed more from lack of supply than lack of demand. Early in 1989, Israel adopted a horizontal band, allowing limited foreign exchange rate flexibility (±3 percent), which replaced the previous regime of a fixed peg with periodic—and not infrequent—devaluations (see Section III).

    In 1989 the BoI began selling call options on the U.S. dollar by means of auctions to the commercial banks. (Because of legal restrictions, the central bank could not deal directly with the public or business sector, and the restriction of operating exclusively through commercial banks was itself seen as a considerable disadvantage.) The BoI wanted its involvement in call options to serve as a catalyst to developing the market, and therefore carefully limited its role so as to avoid substituting for private sector activity. The amount issued was set at $24 million per week, and never increased. Although the total amount issued was capped at $24 million per week, changes were made in issuance policy: put options and six-month maturities, in addition to the original three-month contracts, were added.

    The market developed steadily thereafter. An over-the-counter (OTC) market began in 1990, and in 1994 the Tel Aviv Stock Exchange began trading options contracts (in 2002 it added NIS/euro contracts). In 1996, volume in both the OTC and the Stock Exchange began increasing rapidly. Because the amounts issued by the BoI remained the same, their share in the market shrank steadily: By 2004, BoI options accounted for less than 3 percent of outstanding options and less than 0.5 percent of turnover. In 2005, the BoI ceased issuing three-month foreign exchange options, but continued issuing six-month contracts. By that time, the market was well established and stopping the issuance of these products had no noticeable effect on options trading.

    The active role played by the BoI undoubtedly acted as a catalyst, at least partially, in developing the foreign exchange options market. Although the claim can be made—quite rightly—that such a market would have developed on its own, the initiative of the central bank certainly accelerated its appearance, and quite probably made the process more efficient. In addition, the BoI options provided an important source of data and information on exchange rate developments and expectations.

    The BoI had less success in promoting the use of interest rate hedging instruments. Interest rate exposure was less recognized and hardly managed at all. This situation was the result of a history of high inflation, widespread indexation of financial assets and liabilities, a fragmented market, and extensive government interference. By 1990, the focus of the BoI’s monetary policy shifted to interest rates. In that year, the BoI began to auction three-month future contacts based on 3- and 12-month treasury bills, in an effort to spur the practice of interest rate hedging.

    Interest rate risk hedging markets developed much more slowly than did those for foreign exchange risk, and have remained fairly small and illiquid. OTC trading of interest rate forwards developed sporadically, and exchange traded contracts were introduced only in 2000, and discontinued shortly thereafter owing to low trading volumes. In 2004, total outstanding OTC interest rate derivatives reached NIS 4 billion, compared with NIS 160 billion for foreign exchange derivatives. This ratio differs substantially from international experience, where interest rate derivatives comprise 80 percent of outstanding derivatives positions, far greater than the 14 percent share of foreign exchange derivatives.

    The lack of development of interest rate hedging remains a puzzle, but a number of factors can be cited. Historically, risk was managed through consumer price indexation and real interest rate denominated contracts, rather than nominal interest rate instruments. There has been a shorter history of interest rate volatility, and government debt issuance policy has not always been helpful. The underlying market is illiquid, fragmented, and incomplete and there are still administrative obstacles—no short selling or security lending and no market makers (although there are plans for government bond market makers to begin operations in 2006). The lack of clear enforceability of netting and collateral arrangements has also been an obstacle.

    A Direct Role for the Central Bank

    The central bank can consider taking a proactive role in developing hedging or complementary markets. Its role might include providing incentives or institutional support to products or markets. Central bank policy and operations will often play a role in spurring the development of markets. For example, monetary policy using open market operations will provide a powerful incentive to traded securities markets and the development of repurchase transactions.

    The central bank could also initiate the development of instruments and markets by actually issuing or making a market in instruments such as forwards and options (for example, see Israel’s experience in Appendix Box A1). The case for an explicit central bank role is not clear-cut. Arguments supporting an active role include the possibility of market failure (in the sense of multiple equilibrium, inertia, collusion, or coordination failures); relative advantage of the central bank; or the existence of a development cycle, where there is a natural role for the central bank as a catalyst. Moreover, the argument can be made that risks and costs already exist and in many cases are borne by the central bank; the use of tradable instruments simply makes the role of the central bank more transparent and explicit.

    However, there are also weighty arguments against the central bank taking a direct role in developing financial markets. It is not a core central bank role, and could be counterproductive in the long term if it displaces or crowds out the private sector or introduces distortions and inefficiencies. There is a risk of failure, with implications for the reputation and credibility of the bank. This direct role adds financial risk and operational risks that require the managing of scarce resources; if they are not managed correctly, failures could be costly.

    Given the risks and uncertainties, any direct role for the central bank should be carefully considered and well prepared. If the central bank does decide to play a proactive role, goals should be carefully defined and limited, and the role of the central bank should be delineated and circumscribed from the outset. Milestones should be established so that the central bank role does not become self-perpetuating, and periodic evaluations of market development and the costs and/or profitability of the central bank should be rigorously examined. If safety nets are extended to the private sector, they should be limited in both extent and duration. Costs and incentives should be made explicit, and any incentives should be tied to obligations. Finally, an exit strategy for the central bank should be prepared and strictly adhered to.


    The main points of this appendix can be summarized as follows:

    • FX risk hedging should be encouraged to improve the pricing and managing of risk, increase stability at all levels, and improve welfare. For these goals to be achieved, FX variability should be allowed to increase, regulatory and other obstacles to hedging should be removed, and an appropriate environment should be provided.

    • The development of complementary financial markets is essential to the development of the FX market and brings additional benefits to the financial system, including greater efficiency, completeness, improved monetary policy transmission, competition, diversification, and operational efficiency.

    • The central bank can promote the appropriate environment, assist in establishing the necessary conditions and infrastructure, and take a number of initiatives to help develop FX hedging and complementary markets. In certain cases a direct role for the central bank might be beneficial, but the costs and risks should be carefully considered.

    Prepared by Barry Topf.

    ACI, the Financial Markets Association, has branches in many countries; it undertakes training activities and promotes best market practices.

    The CFA (Certified Financial Analyst) charter is granted by the Certified Financial Analyst Institute.

    The International Swap Dealers Association promotes standard documentation for financial transactions.


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