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The Experience with Floating Rates

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1993
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PETER J. QUIRK AND HERNAN CORTES-DOUGLAS

During the 1950s and 1960s, it was easy for developing countries to say they would peg their currencies to those of the major industrial nations, for by linking their currencies to the dollar, for example, they were effectively fixing the rate against the yen, deutsche mark, French franc, and British pound. The entire Bretton Woods system, of which the IMF was the guardian, was based on fixed rates. In fact, when Milton Friedman made his classic case for flexible rates in developed countries in 1950, he had few followers, even in academia. But when industrial countries chose flexible rates in the early 1970s, the determination of the exchange rate arrangement and the choice of the currency peg became major policy issues for developing countries. This question took on more urgency in 1973 with the first oil price shock, and again in 1982 as the debt crisis began to unfold. The problem was that until recently, there has been a widespread belief that freely floating rates in developing countries would not work. The argument was that for countries to successfully operate market-determined exchange rates, they would need very sophisticated financial structures—such as forward and futures markets—that were often lacking in developing countries. There has also been a concern that floating the currency in the context of serious balance of payments difficulties could lead to a steep fall in its value, which in turn could adversely affect price stability and output in the short run.

These worries, however, are turning out to be ill-founded. Since the early 1980s, 33 developing countries and economies in transition have let their currencies float, the newest ones in Eastern Europe and the former USSR (see box). Recent IMF data on these countries—which includes all those with independently floating arrangements for the period 1985-91—confirm findings from a 1987 study (covering the early experience of only fifteen developing countries at that time) that these countries can satisfactorily operate floating systems. For the countries now gaining or regaining independence, this means a wider range of choices when it comes to picking an exchange rate regime.

Reasons for floating

The debate over the merits of floating versus fixed or “anchor” regimes is not a new one. The supporters of floating rates have long pointed to the inevitability of these regimes when, for example, international reserves are low or nonexistent, while supporters of fixed rates have long underlined the greater certainty that these rates offer for private decision making. Governments, however, have been increasingly motivated to adopt floating rather than other forms of exchange arrangements—such as pegs to single currencies or currency baskets, or managed floating whereby the exchange rate is moved administratively according to various economic indicators.

Insufficient reserves. This has been the most conspicuous reason, for without sufficient reserves, a commitment to defend a fixed or crawling peg exchange rate has not been credible and has been quickly tested by the foreign exchange markets. Foreign exchange transactions now top $1 trillion a day worldwide, and information on even the remotest speculative or arbitrage possibility flows almost instantaneously by satellite or wire, meaning that governments need large resources to hold a rate against market sentiment. At the time the float was initiated in the countries studied, most had experienced a decline in their gross official international reserves to less than three months’ worth of imports (this was also the case in Russia, Latvia, Lithuania, and Ukraine in 1992). The exceptions were Brazil, Ghana, Nigeria, and Paraguay, but the usability of their reserves was limited, in large part because of sizeable external payments arrears.

For information on the 1987 study, see “Floating Exchange Rates in Developing Countries,” by Peter J. Quirk, Bénédicte Vibe Christensen, Kyung-Mo Huh, and Toshihiko Sasaki, Occasional Paper No. 53.

Information requirements. It is difficult for any country to try to determine a sustainable equilibrium exchange rate under fixed or crawling regimes, and the task becomes even more complicated if the country is undertaking extensive macroeconomic and structural reforms (e.g., privatization, reducing the size of the state, and trade and foreign exchange liberalization). If the rate is set at a level far from equilibrium, the resulting effects may lead the authorities to reset the rate to rectify such errors, which in turn could undermine confidence and the clarity of signals of the direction of government policies in the early stages of reform.

Macroeconomic instability. This has been evident in most of the countries opting for floating (e.g., Brazil, Peru, Romania, Russia, and Zaїre), in the form of continuing high rates of inflation in the early stages of reforms or the absence of sufficiently strong programs. In these circumstances, fixed or crawling exchange rates could not be adjusted quickly enough to keep up with price realignments and neutralize significant arbitrage possibilities against the parallel market exchange rate. The authorities thus had little choice but to allow direct market determination of the exchange rate if they were to avoid a shift of foreign exchange transactions to the parallel market, with its adverse consequences in tax evasion, criminalization, and loss of economic control. Indeed, a desire to stop importing inflation from Russia led Latvia and Lithuania to float their new currencies in the second half of 1992 (see “The Ruble Area: A Breaking of Old Ties?” in this issue).

Estonia, on the other hand, with ample international reserves, opted to peg to the deutsche mark in the context of a currency board. A full currency board arrangement is one type of fixed rate regime that can enhance the credibility of macroeconomic policies (the board assures convertibility by insisting on the necessary foreign exchange backing before new currency is issued). But even then the board must be supported by consistently strong fiscal and monetary policies, and the penalty for policy slippage in terms of credibility is high.

Political considerations. Finally, the choice of an exchange rate regime cannot be divorced from these considerations. In most instances, the sampled countries were in such dire economic straits that the authorities saw considerable merit in letting the market be responsible for the adjustment of the exchange rate—this automatically reduces the influence of lobbies and vested interests. In addition, for the previously centrally planned economies, the shift to market-determined exchange arrangements was an important manifestation of a fundamental change of economic policy.

Developing countries and economies in transition now oper a ting floating exchange rate systems include: Afghanistan. Albania, Bolivia, Brazil, Bulgaria, Costa Rica, Dominican Republic, El Salvador, The Gambia, Ghana, Guatemala, Guyana, Haiti. Honduras, Jamaica, Latvia, Lebanon, Lithuania, Mozambique, Nigeria, Paraguay, Peru, the Philippines, Romania, Russia, Sierra Leone, South Africa, Sudan, Uganda, Ukraine, Venezuela, Zaire, and Zambia.

Setting up the market

Once a country decides to float its currency, the authorities must grapple with the extent to which the market should be centralized. Essentially two options are available: an auction market, in which the central bank plays a key role by deciding the amount of foreign exchange to be auctioned, or a private sector (“interbank”) market, in which commercial banks and sometimes foreign exchange dealers handle all of the transactions.

In the early 1980s, a number of countries experimented with the auction approach, but as the IMF’s 1987 study showed, the results—destabilizing intervention, ad hoc controls, and discontinuities in the supply of foreign exchange to the market—left much to be desired. Since the mid-1980s, auctions have been introduced as supplements to extensive commercial bank markets, or as limited secondary dual markets, with mixed results. In Nigeria, where an auction market was used to distribute the foreign exchange proceeds of oil exports to banks and from there to the foreign exchange market, there have been large spreads between the auction and market exchange rates, leading to sustained excess profits for participating banks. In Russia, however, where the auction was introduced as a complement to the market in April 1991 for export proceeds of enterprises (although non-bank residents also participate in the auctions), the process has been relatively smooth. So far, the main lesson appears to be that auctions require a significant commitment on the part of the authorities to ensure transparency and competitiveness, although the very choice of this centralized approach may send a signal that the commitment is lacking.

For countries that choose the interbank market, a key question is whether nonbanks (such as bureaus of exchange and hotels) should be included. Most of the larger developing countries have had a sufficient number of banks to make cornering of the market by a bank or group of banks unlikely. Even so, most have licensed nonbank dealers to work alongside the banks. One possible drawback of including nonbanks is that, given the continued use of capital controls, it is easier to monitor banks, which must meet extensive reporting requirements. However, widespread capital flight in the 1980s, despite extensive capital controls, raises questions regarding the effectiveness of any monitoring mechanisms. Nonetheless, many countries have concluded that the inclusion of licensed nonbank dealers is well worth the monitoring costs, because it leads to a better customer service network and provides insurance against market rigging.

The role of the IMF

Where does the IMF fit into this picture? Under the IMF’s Articles of Agreement, countries are free to adopt the exchange arrangement of their choice; the regime chosen, of course, should be consistent with the country’s obligations to the institution. The IMF advises on the implications of various types of arrangements—in particular, whether the mechanism chosen helps the adjustment process and leads to balance of payments viability, and whether it is consistent with the IMF’s rules and practices, including those associated with the use of IMF resources.

The IMF also provides technical assistance on adapting the foreign exchange market to the particular circumstances of the member. This includes broad policy and technical aspects of market design; the formulation of foreign exchange laws and regulations; the integration of these laws and regulations with trade, capital, and monetary policies and controls; establishing central bank foreign exchange operations; developing regional payments systems; introducing new national currencies; and developing forward foreign exchange markets.

The pursuit of flexible exchange rate policies is an important—and often a conditional—ingredient in the design of members’ financial programs supported by the use of IMF resources. In many cases, these programs have featured the adoption of floating exchange regimes as a mechanism to address problems of severe disequilibrium in exchange markets. In the 1987 review, for example, it was noted that one quarter of all programs in the period 1983-86 envisaged adoption or maintenance of such arrangements. This close association has continued: of 51 arrangements for the use of IMF resources outstanding as of December 31, 1992, 18 were with countries maintaining floating rates. Further, of the 24 floating arrangements adopted in 1985-92,15 took place either as a performance criterion or associated action in the context of an IMF program. In part, these figures are a reflection of the realities of today’s economies—a trend toward more flexible arrangements—as many countries not using IMF resources are also floating.

Domestic policies make a difference

Venezuela is a typical case of a country that adopted floating exchange rates and followed moderate monetary and fiscal policies under an IMF- supported adjustment program. Instead of a free fall, the exchange rate depreciated moderately after floating (following the trend of parallel market rates), and strong capita! inflows permitted the parallel rate to depreciate less than the official floating exchange rate. Moreover, the inflation and growth pictures improved.

In contrast, Russia is one of the countries that adopted floating in the midst of macroeconomic disequilibrium, but where, after a few months of declining inflation {through July 1992), expansive domestic policies fueled an acceleration of inflation and further depreciation of the currency.

The shaded area represents the period after exchange rates floated.

Source: IMf, International Financial Statistics

How countries have fared

With more than a decade of experience behind us, we can at last examine carefully how developing countries have performed following the adoption of floating rates. Interestingly enough, evidence gathered at the IMF strengthens the early indications (see charts).

Do parallel market rates closely follow the money supply? Even prior to floating, this is one of the first questions that needs to be answered, as in the end, it is the rate itself and not the regime that is important. Large differences between official and market-determined (parallel) exchange rates signal that the official rate is not viewed as realistic by the market. It is, therefore, useful to consider evidence that such market-determined rates are important in some more fundamental sense than market sentiment.

To do this, the IMF looked at the relationship between parallel market rates and broad money (lagged one period) for a sample of 13 major developing countries over the period 1977-89. The result was a remarkably strong direct correlation between the two variables. This suggests that while official rates have been held by governments at often inappropriate levels, exchange markets took account of the strengths and weaknesses of monetary policy.

Will currencies go into a free fall?

This second question is based on the fear that once let loose, the exchange rate would tumble—which would be tough politically—thereby aggravating the inflationary forces. But a striking feature of the experience with exchange rate movements after floating is that they have been broadly similar to those of parallel market rates before floating. The fixed or managed regimes in place before floating did not eliminate, or even greatly smooth official exchange rate movements, and these movements broadly followed those of the parallel rates, but with a considerable lag.

In several countries, the official exchange rate remained less depreciated than the parallel rate after floating, reflecting a premium associated with continuing exchange controls (Guatemala, Guyana, the Philippines, Peru, and South Africa,), or market imperfections (Nigeria, as discussed above). In some others, the parallel rate was less depreciated than the official exchange rate after floating (Brazil, Venezuela, and Zaїre), indicating either the influence of strong capital inflows into the entire system (Venezuela) or growing avoidance of the official arrangements. In countries where large reflows occurred following floating and liberalization (e.g., El Salvador, Nigeria, and Venezuela), the reversal was generally anticipated but the speed of the turnaround and the size of the inflows were nevertheless surprising. Such a reversal has also taken place recently in Jamaica, which liberalized remaining exchange controls and interest rates in 1991 after floating its currency in 1983.

In many countries, the initiation of floating arrangements continued a process of real effective depreciation and improving competitiveness that was already underway (Guyana, Nigeria, the Philippines, South Africa, Uruguay, Venezuela, and Zaire). The exceptions were Brazil and Peru, where inflation was particularly rapid; El Salvador and Guatemala, where a small appreciation in the one or two years following floating reflected a strengthening of economic policies; and Paraguay, owing to large depreciations in neighboring countries. In Bolivia, the shift to floating reversed a deterioration in competitiveness beforehand.

What will happen to major economic indicators? The short answer to this third question is that economies generally performed better after switching to floating. These macroeconomic improvements that followed the shift to floating arose in the context of the adoption of comprehensive stabilization programs. Of the twelve countries surveyed for the period 1985-92, inflation declined in six countries following floating (Bolivia, Brazil, The Gambia, Peru, the Philippines, and Venezuela) and accelerated in one (Nigeria). In the other cases, inflation was broadly unchanged, as it was in Paraguay following an initial upturn. As for output, the story is surprisingly positive. For eleven countries surveyed for the period 1985-92, six countries experienced faster GDP growth after floating—Bolivia (with a one-year lag), Nigeria, Peru, the Philippines, Uruguay, and Venezuela (after a one-year lag)—and in two (Brazil and Paraguay), growth deteriorated.

Implications of findings

After a decade of experimenting with flexible rates, the evidence is building that developing countries with diverse economic structures can satisfactorily operate floating rate systems, even if they have relatively simple financial systems. The key is to support the floating arrangements with conservative monetary and fiscal policies to ensure macroeconomic stability—a rule that holds for all countries regardless of their exchange regime.

Although resort to floating has often been in response to an exchange crisis, the experience shows that a priori arguments against floating are not valid. Floating rates do not necessarily lead to a free fall of the currency, nor do they imply higher inflation or lower output. Rather, the experience of countries adopting floating indicates that if the right monetary and fiscal policies are in place, the economic indicators can be expected to improve. The importance of monetary policy is highlighted by the fact that parallel market exchange rates before and after floating closely follow the money supply.

What does this imply for countries now introducing new currencies and in the process of structural economic transformation? Certainly, the success of independent exchange rate floating has already convinced many of them to adopt floating rates. This is the case for Russia and all but one (Estonia) of the newly independent states of the former USSR that have completely abandoned the ruble area (i.e., declared the ruble nonlegal tender)—namely, Latvia, Lithuania, and Ukraine.

It is too early to assess the impact of these floating arrangements in the states of the former USSR, but in Russia, inflation has been more rapid than depreciation of the ruble because of the government’s loose monetary and fiscal policies. Latvian rubles and Lithuanian talonas have significantly appreciated against the ruble since floating began, while Ukrainian karbovanets have depreciated dramatically against the ruble, reflecting highly expansionary domestic policies. As for the other states that may still opt to leave the ruble area and introduce their own currency, their low levels of reserves should be a strong argument to lead them to adopt flexible exchange arrangements.

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