Real exchange rate rules have recently been adopted by a number of developing countries as a means of maintaining international competitiveness in the face of high domestic rates of inflation. The conventional wisdom holds that such rules will quickly lead to hyperinflation, an outcome that is not consistent with the experience of at least some of the countries that have adopted them. This paper shows how real exchange rate rules can easily have destabilizing effects on the inflation rate without leading to hyperinflation, and shows that such effects are difficult to overcome even when supplemented by an appropriate money-supply rule.
This note addresses key issues with respect to trade policy in financial services and its linkages to capital flows, and prudential regulations and supervision under the General Agreement on Trade in Services (GATS), preferential trade agreements (PTAs), and bilateral investment treaties (BITs). The note should help inform the advice that country teams provide on such issues in the context of surveillance, program negotiations, and technical assistance. It is a response to the Executive Board’s call for guidance in this area stemming from the 2009 IEO Evaluation of IMF Involvement in International Trade Policy Issues.
The case studies document the regulatory and supervisory dimension of episodes during the recent crisis involving capital flows that generated systemic stress. Source country regulation and supervision is the main focus, although recipient country policies also were important in some cases and are thus covered as well.
Three of the case studies are motivated by systemic stress that arose from flows between advanced economies. Strong demand by foreign investors for U.S. financial products helped drive gross flows between the United States and other countries, especially Europe, and induced the U.S. financial sector to develop products that transformed their risky assets into highly-rated securities. In turn, large European banks came to depend on short-term liquidity provided from the U.S. These two-way capital flows created a complex web among markets and institutions, some regulated and some not. Against this background, case studies were prepared for European banks and U.S. money market mutual funds (MMMFs) and for German banks and U.S. mortgage-backed securities (MBSs). Another important case is that of the near failure of the American International Group (AIG), which turned out to have complex and systemically cross-border linkages with other global institutions and markets.