Any attempt to analyze exchange rate trends in the volatile 1990s has first to come to grips with the frequent disconnect between what exchange rate regimes were called and how country authorities actually managed their exchange rates. In early 1999, IMF staff took a first step toward fashioning an internally consistent “de facto” classification system. This new system sorted exchange rate regimes according to actual exchange rate policies rather than by member country descriptions, which were often based on legal considerations. The de facto classification is now routinely published in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions and International Financial Statistics.
In its analysis of exchange rate regimes, the new IMF study applies the de facto classification to the post-1990 period and finds that there have been important changes in exchange rate regimes (see chart, page 345). Countries have moved away from intermediate exchange rate regimes toward floating and, to a lesser extent, hard pegs (see box below for definitions). The study also finds that the momentum of liberalization—especially of capital transactions—appears to have diminished, possibly reflecting growing concerns about the risks associated with sudden reversals of capital inflows. These developments, combined with macro-economic fundamentals and foreign exchange market organization and regulations, the study suggests, may have affected exchange rate volatility.
Types of exchange regimes
The IMF’s new de facto categorization of exchange rate regimes identifies eight types of regimes, which can be divided into three broad groups:
• Floating exchange rate regimes include independently floating regimes (in which the exchange rate is market determined, with intervention only to moderate exchange rate fluctuations) and managed floating regimes with no predetermined path for the exchange rate.
• Intermediate exchange rate regimes include soft pegs (conventional pegs to a single currency or a basket of currencies, horizontal bands, and crawling pegs with and without bands) and tightly managed floating regimes (under which authorities attempt to keep the exchange rate stable without any commitment to a predetermined path).
• Hard peg regimes include currency boards and exchange rate regimes with no separate legal tender (such as formal dollarization and currency unions like the CFA franc zone and the euro area).
Important, but complex, shifts
Although the de facto classification system indicates a shift away from intermediate regimes, this shift has been less pronounced than implied by the earlier de jure classification system. The polarization of exchange rate regimes appears to have been more pronounced in countries that already had access to international capital markets. Moreover, in the past decade, intermediate regimes tended to be more prone to market pressures than floating or hard peg regimes.
This evolution in exchange rate regimes also reflects the changing role of the exchange rate in monetary policy frameworks and the increasing degree to which many countries have been integrated into international capital markets. In particular, the study found a drop in the use of the exchange rate as a nominal anchor or intermediate target of monetary policy. Meanwhile, an increasing number of countries have adopted an inflation targeting framework, although the exchange rate still plays an important role in monetary policy where prices move closely with the exchange rate. Many countries with intermediate regimes and greater access to international capital markets have either opted to move toward more flexible regimes to gain greater monetary policy autonomy or been forced to do so in the face of severe pressures on their currencies. Only a few countries have adopted hard peg regimes after exiting from intermediate regimes.
The IMF’s de facto classification system has helped clarify both the nature and the role of members’ exchange rate regimes. It has facilitated discussions with country authorities about how exchange rate regimes are implemented and has contributed to more effective surveillance of the international monetary system. But assessing actual exchange rate policies isn’t always an easy task. It has proved particularly difficult in cases where countries informally target the exchange rate through direct or indirect intervention while officially announcing a floating exchange rate regime. Timely information and a transparent presentation of how exchange rate regimes function are crucial ingredients for accurate classification.
Are exchange controls an option?
The number ofcountries maintaining exchange controls during 1998-2000 reflects a slowdown in efforts to liberalize current, but more especially capital, account transactions. The study observed that the share of IMF member countries maintaining “exchange restrictions” on payments and transfers for current international transactions (such as limits on foreign exchange allowances, advance import deposits, and arrears to commercial and official creditors) declined to about 20 percent by the end of 2001, from 30 percent at the end of 1997. However, the share of countries with “exchange controls”—a broader concept that includes other measures in addition to exchange restrictions—fell only slightly, to about 70 percent of total IMF members by the end of 2001, from 74 percent at the end of 1997. Moreover, virtually all members continued to maintain some types of controls on capital account transactions, although some measures were used for prudential and other purposes and were not designed explicitly to restrict cross-border capital flows.
The IMF study found little correlation between the use of exchange controls and the degree of flexibility of exchange rate regimes or the occurrence of currency crises. Excluding countries in the euro area, which are classified as maintaining hard peg regimes and impose virtually no controls on current or capital transactions, no clear relationship appeared between the exchange rate regime and the use of controls on current transactions. Nor was a specific pattern evident with respect to capital controls. Countries that experienced crises tended to resort to exchange controls to reduce pressure on the exchange rate, although no systematic patterns were found in the choice of controls these countries imposed.
Foreign exchange market organization
IMF staff assessed the organizational structure of the foreign exchange markets in a broad range of developing and transition countries in 2001. Foreign exchange markets have an important role to play in the global economy, but surprisingly little systematic information is available on how they are organized. This survey—the first study to collect information on a wide range of institutional and regulatory features affecting foreign exchange trading—noted that foreign exchange intermediation is usually conducted by authorized dealers, who buy and sell on their own account for end-users and providers of foreign exchange as well as between each other. Most countries seek to influence foreign exchange market organization through regulation, which can significantly affect exchange rate dynamics and may lead to the emergence of multiple foreign exchange markets. In addition, in the vast majority of countries, the central bank is an active participant in the foreign exchange market, though the form this participation takes varies widely.
Exchange rate volatility
Notwithstanding technological and financial innovations, many countries continue to experience high exchange rate volatility. As financial markets around the world become more integrated, volatile exchange rate movements in one country can spill over to other countries—as recent financial crises have demonstrated. All of this underscores the need to better understand the factors affecting exchange rate volatility. The IMF study recommends that greater attention be given not only to macroeconomic fundamentals but also to other factors, especially the structural features of foreign exchange markets, the type of exchange rate regime, and the presence of exchange regulations.
Some structural features of foreign exchange markets appear to influence exchange rate volatility. Even after taking into account other features—most notably, aspects of macro-economic performance such as inflation, real GDP growth, and fiscal deficits—countries with decentralized foreign exchange dealer markets tended to have lower volatility in 2001. The type of exchange rate regime also appears to affect volatility; for example, countries with an independently floating regime tend to have greater volatility, while those with a crawling band regime tend to experience less volatility. In addition, the presence of exchange restrictions appears to be associated with greater volatility, while some prudential and foreign exchange market regulations (for example, limits on net foreign exchange open positions and restrictions on monetary use of domestic currency by nonresidents) are associated with less volatility.
Countries have moved away from pegged exchange rates
1 Includes arrangements with no separate legal tender, currency boards, conventional fixed pegs, horizontal bands, crawling pegs, and crawling bands.
2 Of IMF membership.
Data: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, various issues
The full text of Exchange Rate Regimes and Foreign Exchange Markets—Developments and Issues will be available shortly in the IMF’s World Economic and Financial Surveys series.