The exchange and payments crises of the 1990s, the general increase in capital mobility, and the boom-bust character of capital flows to developing countries raise anew the issue of appropriate exchange rate arrangements, according to an IMF study to be published in the IMF Occasional Paper series. The study—Exchange Rate Regimes in an Increasingly Integrated World Economy—was prepared by a team from the IMF’s Research Department. On April 14, IMF Economic Counsellor and Director of the Research Department Michael Mussa held a press briefing to discuss the study. Participating in the press briefing were two principal contributors to the study—Alexander Swoboda, Senior Policy Advisor, on leave from Geneva’s Graduate Institute of International Studies; and Paul Masson, Senior Advisor, currently on sabbatical at Georgetown University and The Brookings Institution.
Mussa explained that the International Monetary and Financial Committee asked IMF staff to reexamine the issue of exchange regimes in light of important changes that have been taking place in the world economy. In particular, the staff was asked to study the implications of the increase in international capital mobility and in the participation of many developing countries—so-called emerging market countries—in the international financial system.
“We took our task to be a comprehensive one,” Mussa said. “The IMF is a virtually universal organization, and we wanted to look at the issue of exchange regimes across the entire membership—from the largest industrial countries, whose national currencies form the main foundation of the international monetary and financial system, to the smallest members of the IMF.”
Not surprisingly, Mussa said, with such a wide range of countries at varying levels of development and with varying degrees of financial sophistication, one cannot expect to reach a uniform conclusion about a single exchange rate regime that would apply universally to all of those countries. Perhaps the single most important conclusion of the analysis, he said, is that “there is no single exchange rate regime that is best for all countries, at all times, in all circumstances.”
This conclusion does not mean, of course, that “anything goes,” Mussa cautioned. Certain types of exchange rate regimes, he said, do seem better suited to some countries, in some circumstances, at some times.
Key currency relationships
The launch of the euro in January 1999 marked a new phase in the evolution of the postwar international financial and exchange rate system, Swoboda noted, including a rearrangement of the relationships between the system’s key currencies. The IMF study suggests that the volatility observed in the past—notably between the U.S. dollar and the deutsche mark—is likely to continue in the future between the euro and the other currencies, particularly the U.S. dollar. The euro area as a whole is a more closed economy than its components, he said, and the European Central Bank (ECB) has a clear mandate to focus monetary policy on inflation rather than on the exchange rate.
The study also looked at the medium-run prospects for more active management of the major currency exchange rates, Swoboda said. Proposals have ranged from a “world central bank” at one end of the spectrum to absolute, clean floating at the other extreme, with some form of target zone somewhere in the middle. But the study predicts that relations between the three major currencies will be much closer to the pure floating end of the spectrum. Given the high degree of capital mobilization, there is just not enough political commitment to stabilize exchange rates in a narrow range in a world of high capital mobility, he said, and “we do not see the U.S. Federal Reserve or the ECB sacrificing domestic objectives for the pursuit of exchange rate stabilization.”
Photo Credits: Denio Zara, Padraic Hughes, Pedro Márquez, and Michael Spilotro for the IMF; Michele Iannacci for the World Bank, pages 150 and 151.
There is a trade-off between stabilizing the exchange rate and stabilizing the domestic economy in the three major currency areas, Swoboda said. Volatility is not necessarily a cause for concern if it reflects a change due to the major economies being at different points in the business cycle, rather than a gross misalignment between their currencies. However, large and prolonged misalignments of the major exchange rates are a cause of serious concern both for the major countries themselves and for the rest of the world, he stressed. There is definitely a role for IMF surveillance and for concerted action on the part of the Group of Three and the Group of Seven to avoid the most severe forms of imbalances.
Exchange regime for developing countries
The current international environment is characterized by a substantial degree of flexibility, Masson said, and developing countries’ choice of exchange rate regimes has to be conditioned to that environment. However, the individual circumstances of each developing country will also influence the choice of exchange rate regime, ranging from substantial flexibility to a currency board or monetary union. In the middle range of choices, Masson noted, are various forms of regimes—like crawling bands and adjustable pegs—that are characterized neither by substantial flexibility nor by a commitment to a fixed and unchanging peg.
It has been argued that this middle range of regimes is likely to disappear because it is unsustainable, especially for those countries pursuing closer integration into international capital markets. The study, Masson said, acknowledges that greater capital market integration does make the requirements for sustaining exchange rate regimes that are not at either extreme more demanding. But the policy requirements for maintaining a successful and stable floating regime, or continuing with a strong commitment to a fixed peg, are more demanding.
Although developing countries appear to be moving toward increased flexibility, Masson said it is likely that the current range of regimes will continue in the future. Some of the considerations influencing the choice of exchange rate regime include, for instance, the degree of diversification of trade, where the flexibility among the major currencies will cause some problems for single-currency pegs, given that pegging to one of the major currencies will imply substantial fluctuations relative to the others.
Single-currency pegs, however, are at present, and will no doubt continue to be, highly desirable regimes for countries with a strong concentration of trade with one of the major blocs. For countries moving to greater exchange rate flexibility, an alternative to the exchange rate as a nominal anchor needs to be developed, as well as institutions to sustain that alternative anchor.
For countries moving to greater flexibility, it is unlikely that benign neglect of the exchange rate—that is, a perfectly free float—is going to be desirable, Mas-son said. Sustainable free-floating regimes require deep foreign exchange markets, and developing countries typically lack this feature. So, some degree of intervention and concern for movements in the exchange rate in setting monetary policy is likely to persist.
In response to a question about the temptation to stop a currency from appreciating through a de facto pegging of the exchange rate and whether such an action could create the same problems that led to the Asian crisis, Mussa said that, with the exception of Malaysia, the Asian currencies are formally floating. “We remain concerned, however,” he said, “that if there were a return to de facto pegging, this could re-create some of the problems we saw develop in Asia.”
“So it is important,” he stressed, “if you have a floating exchange rate regime, that the exchange rate really does float in response to market forces and that businesses—when they are trading, and particularly when they are borrowing and lending and engaging in capital market transactions—recognize that there really is a foreign exchange risk. That is to say, the exchange rate will move, and businesses do not have an implicit guarantee that the government will step in to rescue them if they make bad judgments about structuring their businesses and balance sheets.”