VI Policy Options in the Aftermath of the Crisis

International Monetary Fund
Published Date:
January 1993
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During its discussions with officials and with private market participants, in the aftermath of the crisis, the staff heard a large number of suggestions and proposals for managing exchange rates.32 These suggestions spanned the characteristics of exchange arrangements, the credibility of interest rate policy, the nature of intervention arrangements, and the adequacy of the regulatory framework (pertaining to position-taking in the forex market); most of the proposals were directed specifically at the ERM, but some had a wider orientation. This section attempts to give the “flavor” of some of those ideas.

Characteristics of Exchange Arrangements

Putting “Adjustable” Back into “Fixed and Adjustable Peg”

The suggestion here is to have more frequent, small changes in exchange rates within the band—so as to move the ERM closer to what its proponents regard as its original design (namely, a system of stable, but adjustable par values). The aim is to “depoliticize” exchange rate adjustments and to restore the “two-way” bet for speculators. The exchange rate changes themselves could perhaps be made with respect to a set of indicators and would presumably provide less than one-to-one offset for inflation differentials. By removing the prospect of large realignments and by putting more responsibility for exchange rate changes in the hands of technicians, these changes seek to take away what the speculators like most—that is, large profits from the collapse of large misalignments. Also, by allowing the exchange rate to assume more of the burden of adjusting to both country-specific real shocks and different speeds of disinflation across countries, there would be less pressure on interest rate coordination. On the negative side, some observers expressed skepticism about the ability actually to depoliticize exchange rate adjustments. A more fundamental concern is that such a “softening” of the exchange rate commitment in the ERM would entail a simultaneous weakening of policy discipline—particularly in the member countries that still had a long way to go to meet the Maastricht criteria on inflation, interest rates, and fiscal convergence.

Wider Margins

Again, the motivation here is to discourage “oneway” speculative bets, to allow the exchange rate to play more of a “safety valve” function when progress on economic policy convergence proves less rapid than anticipated, and to place less of a burden on interest rate coordination and on mandatory exchange market intervention.

Move More Rapidly to EMU

No suggestions were heard that the Maastricht Treaty should be renegotiated. Still, some observers felt that the recent exchange market crisis had validated their fears, namely, that ERM parities would be most vulnerable during Stage II on the way to EMU. The lifting of capital controls, combined with country-specific shocks and incomplete monetary policy coordination, could produce a flammable compound. The way to go was to move conflicts over monetary policy out of the newspapers and into the boardroom of a European Central Bank (ECB) and to remove the inevitable doubts about “irrevocably fixed” exchange rates by adopting a single currency. The longer the delay in making this jump to Stage III, the greater would be the likelihood of further exchange rate crises. Those opposed to this option emphasize the sizable divergences in economic performance and policies that still exist within the EMS and the adverse effects that this lack of convergence would have on the union’s common monetary policy and on incentives for further convergence around sound fiscal policies.

Leave ERM Design as It Is but Improve Rule Implementation

The proponents of this view argue that future crises could be avoided if member countries would respond more quickly to market pressures; once authorities delay and become embroiled in a full-scale battle of resources with the private sector, it is too late. Countries should instead take interest rate action early and intervene well before exchange rates hit the bottom of the band. Small exchange rate adjustments within the band may sometimes also be needed. The key is to build up credibility gradually by showing the markets that whenever there is a potential conflict between the internal and external requirements for monetary policy, the exchange rate is king. Once the markets learn that countries are not schizophrenic about monetary policy and that exchange rate adjustments—when they occur—will be small, attacks will cease. Countries could meanwhile continue the convergence process toward EMU. Moreover, the recent changes to the parity grid have produced a more realistic set of parities. Also, as inflationary pressures in Germany continue to recede and, in turn, enable interest rates to be cut significantly, disagreements about the appropriate course of monetary policy will diminish. Doubts about this option center on the weight it gives to interest rate coordination in a world in which significant differences still exist between the internal and external requirements for monetary policy in certain EC countries, and on the system’s ability to avoid future attacks when the political calendar (as well as future EMU entry decisions) provides a natural focal point for speculators.

Interest Rate Policy

Give Greater Independence to Central Banks

The line of argument is that exchange rate credibility depends on interest rate credibility, and that interest rate credibility in turn is difficult to acquire without an independent central bank. Those who favor this approach note that those countries that were most reluctant to push up their interest rates early during the ERM crisis were predominantly those with less independent central banks. As hiking up interest rates to defend the currency is typically most unpopular, an independent central bank can take that necessary but unpleasant medicine more quickly than a less independent one.33 If interest rate increases are too long delayed, the capital markets may have overwhelmed the country’s exchange rate defenses. Those less enthused about this proposal argue that only one central bank (the anchor country) in a system of fixed exchange rates can have monetary policy independence—whatever the charters of central banks. They also note that independence can sometimes mean inflexibility—much to the detriment of economic policy and performance (particularly when sustainable growth, rather than just low inflation, is brought into the picture). Moreover, they question whether central bank independence (beyond the independence founded on public opinion) is either necessary or sufficient for interest rate credibility.

Invigorate Coordination More Widely

Some observers felt that tensions in the ERM in the run-up to the crisis had been exacerbated by (unduly) low interest rates in the United States and Japan, which, combined with the increase in German interest rates, had put strong upward pressure on the deutsche mark. In their view, the need was not only for better monetary policy coordination within the EMS, but also for taking greater account of the international repercussions of national policy decisions throughout the Group of Ten countries. While not challenging the desirability of improved economic policy coordination more generally, some other participants regarded the recent ERM crisis as predominantly “homegrown”—and likewise saw its solution as lying primarily in closer monetary policy coordination in Europe itself.

Intervention Policy: Re-examine “Unlimited” Obligation

One view was that when the intervention obligations of the EMS were drawn up and the decision made that support should be mandatory and “unlimited” once a currency hit the bottom of the band, it was not envisaged that international capital markets would reach today’s size and influence. The recent crisis has shown that such an intervention obligation could mean that a single strong-currency country would be providing massive amounts of intervention resources—perhaps even beyond its ability to sterilize the impact of those flows on its own monetary stance. Moreover, as there is no guarantee that the country receiving those resources will have either adopted appropriate interest rate action or considered an appropriate change in its exchange rate, those massive resources could help support “unsustainable” exchange rate parities—thereby enriching only speculators. The argument then suggests that either provision of those unlimited intervention resources would need to be conditional on the receiving country taking appropriate interest rate action and/or on it having fundamentals consistent with its existing parity; alternatively, obligations for intervention would have to be shared more widely, as any single country in the ERM is too small relative to the world capital market. In this connection, pooling reserves is a possibility, so that sequential attacks on parities do not put undue pressure on the same creditor.

On the other side of this issue is the concern that either a de facto or a de jure redefinition of intervention obligations within the ERM would damage its ability to counter an already large imbalance between public and private resources for intervention in the forex market. Although it is obvious that in practice intervention cannot be truly unlimited, the formal commitment to unlimited intervention creates uncertainty in speculators’ calculations that even a large-scale attack could be successful.34 Without such uncertainty, the costs and risks of speculation could be reduced, making the system more vulnerable to attack. Such considerations have led some to argue that until the unlimited intervention obligation is replaced by something else, the existing provisions should stand and be implemented according to both the spirit and the legal letter of the arrangement.

Regulatory and Prudential Framework: Re-examine Position-Taking in Forex Market

As exchange rates are volatile assets and position-taking in forex can involve a bank in large losses, it is often emphasized that banks should be holding adequate capital against such positions if the safety and soundness of the banking system are to be protected. There is strong support for the examination now going on within the Basle Committee on Banking Supervision (as part of its broader efforts to include market risk in the Basle Accord) to determine whether banks are holding adequate capital against open currency positions, and if not, to propose new requirements. It has also been argued that the regulatory framework relevant to other large players in the forex market—ranging from securities houses to institutional investors to hedge funds—should likewise be examined by the appropriate authorities, both to ensure a level playing field and to determine whether some of these institutions are not taking excessive risks in their forex operations. A concern exists that a large trading loss (beyond the cushion provided by market-driven capital levels) in an unregulated offshore entity could have potentially serious spillover effects on other institutions. At the same time, it is agreed that, more broadly, care is needed not to overreact to the recent currency turmoil: although it is always prudent to ensure that risks are priced appropriately, caution is also necessary in introducing measures that could unduly restrict the evolving integration and innovation in international financial markets. Proposals that would “throw sand in the wheels” of the forex market (by introducing transaction taxes or new types of capital controls) have met with only very limited support.

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