- Barry Eichengreen, Inci Ötker, A. Hamann, Esteban Jadresic, R. Johnston, Hugh Bredenkamp, and Paul Masson
- Published Date:
- August 1998
There is an extensive literature on the choice of desirable and feasible exchange rate regimes, which includes a discussion of “optimum currency areas,” the choice between fixed and flexible regimes, and money versus exchange-rate-based stabilization. The focus here is on a short practical guide to exchange rate regime choice, rather than an exhaustive survey of the literature. Moreover, it needs to be recognized that there is no agreement on how precisely to quantify the various criteria, nor, to the extent that they conflict, on which should take priority.
Table A1 summarizes the implications for exchange rate arrangements of a number of criteria that have been discussed in the literature. Though not exhaustive, the set of exchange rate regimes listed at the top spans the range from flexible to perfectly fixed, with some overlap between managed flexibility, target bands, and crawling pegs. The criteria listed on the left are thought to influence positively (though not necessarily be prerequisites for) the success of the exchange rate regimes indicated with a dot. Conversely, the criteria are considered not to be compatible with successful operation of the other exchange rate regimes. For instance, high inflation is likely to be compatible only with flexible exchange rates or a crawling peg, while low inflation would permit a choice of any of the exchange rate regimes (but presumably make a crawling peg unnecessary).
|Level of reserves|
|Labor mobility and nominal|
|Production and export|
|Fiscal flexibility and sustainability|
|Relative to partner countries|
|Political integration (similarity of policy preferences)|
|Preponderance of shocks|
|Type of shocks|
While a number of the criteria discussed below are intended to refer to structural characteristics of an economy, it has been pointed out that even these criteria are to some extent endogenous.26 For instance, a credibly fixed rate may lead to a structural break with inflation inertia, while the extent of trade and other links with partner countries may also adapt to joint exchange arrangements. As a result, countries that initially did not seem to be candidates for a fixed exchange rate arrangement would after a certain amount of time score highly on the relevant criteria.
An important factor in the choice of exchange rate regime not stressed by the traditional literature nor captured by the usual economic indicators is the objective function of the authorities, in particular as concerns the trade-off between a desire to control inflation (that is, provide a nominal anchor) and to limit fluctuations in competitiveness (and minimize output losses).27 Hence, two economies with the same structural features may (optimally) choose different exchange rate arrangements. Moreover, changes of government may involve different preferences concerning the trade-off of the two objectives, and hence a change of exchange rate regime.
In evaluating the predictive power of the criteria, two other points also need to be recognized. First, sound fiscal and monetary policies are a prerequisite for any exchange rate arrangement to function well (though a floating rate regime cannot “break down” in the same way as a fixed rate arrangement—its success is judged by reasonable stability in financial markets and good macroeconomic performance). So “optimality” cannot be judged independently of those policies.
Second, sometimes a stabilization program requires a regime change, to make a break with the past, so that questions of optimality are secondary. For instance, if the current regime lacks credibility and risks degenerating into a situation of accelerating inflation, a radical monetary reform—such as instituting a currency board—may be desirable.
Prevailing Rate of Inflation
A basic criterion for a fixed exchange rate is acceptance of a rate of inflation similar to that in the partner country. Too high (and persistent) inflation constrains the ability of a country to maintain an exchange rate peg against a stable (in the sense of low inflation) currency or basket of currencies. Hence, tolerance for inflation would make an extended commitment to a fixed peg or to narrow (fixed) exchange rate bands infeasible. The prevailing rate of inflation (averaged over a certain number of years) may give an idea of the tolerance for inflation.
However, there is evidence that at hyperinflation or very high rates of inflation, inflation inertia is quite low, permitting the use of an exchange rate peg to achieve rapid disinflation without significant costs in economic activity.28 In these circumstances, a pegged rate is likely to be a useful transitional policy, as part of an exchange-rate-based stabilization. In countries with high and persistent inflation (roughly above 30 percent a year), the use of the exchange rate as a nominal anchor has been somewhat less successful, due to inflation inertia and low credibility. Even with strong fiscal adjustment, exchange-rate-based stabilizations in these countries often have led to significant real appreciation and large current account deficits. Also, these experiences often have been characterized by an initial boom, led by consumption spending, followed by a recession associated with the cumulative effects of the real exchange rate appreciation. This contrasts with money-based stabilizations, which typically cause a recession early during the disinflation.
Whether a fixed exchange rate policy designed to stop inflation proves durable depends partly on the extent that the tolerance for inflation and residual inflation inertia has been eliminated. If not, then it is unlikely that inflation could be durably reduced to a level close to that of partner countries, and, as a result, a fixed peg would eventually lead to overvaluation and the need for more exchange rate flexibility. In these circumstances, adoption of a crawling peg and relatively wide bands may be appropriate to avoid significant and continuing real appreciation.
Level of Reserves and Capital Mobility
Without adequate reserves, the monetary authorities may not be able to maintain an exchange rate peg or a target band unless monetary policy (in particular, domestic interest rates) is clearly subordinated to the exchange rate objective. The level of reserves interacts with the extent of capital mobility to influence feasibility. High capital mobility makes it difficult to maintain a regime that is intermediate between the two extremes of floating rates and currency boards, unless stringent requirements of similarity of structures of the economies concerned and convergence of their policy objectives are satisfied. 29 Conversely, if reserves are not very large or the central bank is unwilling or unable to move interest rates in response to exchange rate pressures, then even with only moderate capital mobility it may be impossible to maintain some sort of pegged exchange rate arrangement.
Clearly, the extent of capital mobility and the availability of instruments to the private sector to bet against official exchange rate targets has greatly increased in recent years. As a result, as argued by Obstfeld and Rogoff (1995), exchange arrangements intermediate between complete flexibility and complete fixity have become less credible and more fragile. Nevertheless, in most currency crises industrial countries have had sufficient reserves to fully back the monetary base, and hence could have defended pegged rates (for instance, in the EMS in 1992–93) had they been willing to incur the cost that the resulting higher interest rates would have inflicted on the economy. Moreover, several smaller economics with a history of subordinating their monetary policies to a peg to the deutsche mark have long avoided any exchange rate pressures (Austria, the Netherlands). So the question of feasibility is not an absolute one, but also interacts with other considerations. It is also the case that greater capital mobility can add to the instability of flexible rates, leading to periods of large misalignments.
Extent of Labor Mobility and Nominal Flexibility
For a given level of wage or price stickiness, the costs of loss of flexibility associated with adopting a more rigid exchange rate arrangement would be lower, the greater the extent of labor mobility within a country and between partner countries. This is the fundamental argument of the seminal paper on “optimum currency areas.30 Otherwise, an asymmetric shock reducing the demand for labor in a country or region would lead to an increase in unemployment there. Labor mobility would instead permit (in principle) the workers affected by the fall in demand to migrate to a region where demand was higher.31 In the absence of labor mobility, the exchange rate could change relative prices in a direction of reducing the negative effects of shifts in demand.
In the polar case of flexible wages and prices, exchange rate flexibility would provide no additional policy instrument, since movements in relative prices would occur costlessly. In this case, there would be no reason not to fix the exchange rate, since it would impose stability of nominal magnitudes without leading to a loss of real flexibility. Thus, flexibility of wages and prices would provide a substitute for exchange rate flexibility. Flexibility is difficult to measure, but McKinnon (1963) argues that openness increases the responsiveness of wages and prices to the exchange rate and reduces the scope for using a devaluation to help labor to accept a cut in real wages. Hence, greater openness would argue for greater exchange rate fixity.
Production and Export Diversification
More generally, a country might want to avoid a peg, whether to a single international currency like the U.S. dollar or to a basket of currencies, if its production and exports were not diversified. Diversification makes the country less vulnerable to terms of trade shocks, and hence less likely to need exchange rate flexibility. In contrast, countries heavily reliant on a few commodities may need the flexibility of a floating rate to respond to changes in world prices in order to mitigate spillovers into nonresource sectors.
Assuming that a pegged rate were desired, the choice of a single currency peg rather than a basket would depend on how concentrated were trade (and capital account) links with a particular country and the similarity of their productive structures. For a country whose trade was diversified regionally, a basket peg would make the country less vulnerable to movements in cross rates, which would be important if trade links and production similarity vis-a-vis a particular country are not strong.
Fiscal Policy Flexibility and Sustainability
Fiscal flexibility is more important for exchange arrangements that incorporate more fixity, since the exchange rate instrument cannot be used as a shock absorber. This has two aspects. First, a country with a pegged rate may need to allow its own fiscal policy to respond more flexibly (including allowing automalic stabilizers to operate) in the face of shocks to the domestic economy. Second, in a monetary union it may be desirable to cushion shocks by using fiscal flows across countries in the union, for instance through a federal fiscal system of taxes and transfers.
Fiscal policy sustainability is also important for the survival of a fixed rate system. High public debt not only reduces the flexibility of fiscal policy but also increases the risk of default, a balance of payments crisis, and recourse to monetizaiion of fiscal deficits. High debt makes defense of a peg more costly, involving higher deficits and still higher debt, thereby increasing the risk that speculative attacks may be self-fulfilling. Therefore, the ratio of government debt to GDP may be an indicator of vulnerability of a pegged rate.32
Extent of Trade and Political Integration
The higher the trade integration with partner countries, the greater the benefits of a fixed exchange rate or common currency. The higher the level of international trade between two countries, other things being equal, the greater the reduction of transactions costs (including costs of hedging) that a regime with a high degree of fixity in the two countries’ bilateral exchange rate would bring. In addition, fixed rates, by making comparison of prices more straightforward, should increase their information content and increase economic efficiency. Such exchange rate arrangements could involve pegged rate systems of various types or go so far as the creation of a currency union. The latter needs to involve a high degree of common interests among the countries concerned, that is, a form of political integration, because otherwise the use of a common currency is unlikely to be durable, and hence not credible.
Symmetry and Type of Shocks
If shocks facing two countries are very different, then a fixed exchange rate linking their currencies may not be desirable. Thus, asymmetric shocks are likely to be a problem for pegs or currency unions, The type of shock facing the two economies is also important. A preponderance of domestic nominal shocks, in particular to money demand, suggests that more exchange rate fixity would be desirable, allowing anchoring to a stable foreign country’s price level. In contrast, in the face of real shocks (like the terms of trade shocks mentioned already, but also including domestic real shocks such as those to productivity) the economy would benefit from exchange rate flexibility, which would ease adjustment costs in the presence of stickiness of wages and prices.
The extent of dollarization of the economy wilt influence the exposure to monetary shocks. The associated currency substitution will make the demand for domestic money more interest elastic and sensitive to expectations of future changes in monetary policy. In these circumstances, domestic money demand shocks may dominate real shocks, and, as suggested above, a fixed exchange rate relative to the foreign currency (the “dollar”) that is used domestically may be appropriate.
As has been pointed out by others, the optimum currency area criteria seem to have relatively little predictive power.33 Though they may have prescriptive implications, they may not well explain actual choices among exchange rate arrangements. Therefore noneconomic factors may dominate. In particular, lack of central bank credibility may make it difficult to attain low inflation on a sustained basis by running an independent monetary policy, making it attractive to “borrow” the credibility of a partner country central bank through an exchange rate peg,34 a currency board, or the abandonment of the domestic currency in the context of a currency union. The latter would be more attractive to the extent that the country concerned retained some influence over the common monetary policy in the context of some framework for political integration. Conversely, a floating rate may be chosen for noneconomic reasons, for instance as an assertion of monetary sovereignty.
This appendix summarizes historical experience with exits from currency pegs. It documents past experience with exits, establishing that these have typically been associated with exchange market crises and adverse macroeconomic outcomes.
It should be emphasized that no attempt is made here to isolate the effects of exits. Countries exiting from currency pegs have typically differed from other countries in a variety of other respects besides their decision to change their exchange rate arrangement. The fact that exits have typically taken place in an environment of crisis suggests that such countries may have suffered from an adverse shock or have been running unsustainable policies, either of which can influence the post-exit behavior of macro-economic and financial variables. Inevitably, simple comparisons of countries exiting from currency pegs with other countries reflect more than the effects of the exit, narrowly defined. Therefore, the goal here is more limited. It is to document the historical record with exits and thereby to motivate the discussion in the text of the need to identify better ways of undertaking them.
To this end, a comprehensive list of exits from currency pegs by developing countries was assembled, and a variety of macroeconomic and financial indicators were analyzed around the time of the exit and compared with those for control groups of nonexisting countries. Exits are defined as movements from a (single currency or basket) peg to a more flexible exchange rate policy.35 Since the problem of devising an exit strategy is particularly pressing for developing countries operating in an environment of international capital mobility, the sample was limited to the last two decades (generally, 1977–95, although for some variables the data end in 1992) and to countries considered in the World Bank’s World Development Indicators and Global Development Finance data tables.36 Short-lived experiences were eliminated (to be categorized as an exit, the exchange rate peg regime and the subsequent period of flexibility each had to last at least two years),37 along with unrepresentative economic and political cases (specifically, cases of hyperinflation and civil war where the behavior of macroeconomic and financial variables was so extreme that they would have dominated the results).
This left a total of 29 exits in which countries moved from single currency pegs or basket pegs to managed exchange rates or an independent float.38Table A2 summarizes the exit cases that we were able to include in the analysis of each of the variables examined. Table A3 summarizes the countries in the sample, the size of any devaluation both before and after the exit, the nature of the exchange rate regime before and after the exit, and the date of exit.39 (See Figure A1) The relatively small number of exit cases is reason for regarding the results with caution. In addition, the relatively small number of exits in the sample prevented detailed comparisons of countries that exit in an orderly fashion and countries that exit as a result of a crisis.40
|Year of Exit||Real GDP Growth||International Reserve Grotwth||Liquidity of banking System||Deficit in percent of GNP||Current Account in Percent of GNP||Debt in precent of GNP||Reserves in percent of Imports||Short-Term Dedt in percent of total Debt||Commercial Debt in percent of Total Debt||Variable Debt in Percent of Total Debt||Foreign Investment in percent of Total Debt||M1 Growth||M2 Growth||Consumer Price Index||Export Growth||Import Growth||Capital Account Restrictions||Current Account Restrictions||Nominal Exchange Rate||Real Effective Exchange Rate|
|Yemen, Rep. of||1983||•||•||•||•||•||•||•|
|Total number of observations||21||21||22||19||20||20||18||24||20||19||17||26||26||23||20||20||17||17||26||21|
|Country||From||To||Peg||Month of Exit||Before exit Since exit|
|Chile||A||C||U.S. dollar||June 1982||0.00||92.56|
|Costa Rita||A||D||US, dollar||January 1981||0.00||319.60|
|Ecuador||A’||C||U.S. dollar||March 1983||32.60||81.70|
|Egypt||A||C||U.S. dollar||January I98S||0.00||62.33|
|El Salvador||A||C||U.S. dollar||August 1982||0.00||9.20|
|A||C||U.S. dollar||January 1989||0.00||21.00|
|Ethiopia||A||C||U.S. dollar||October 1992||0.00||71.00|
|Gambia. The||A||C||Pound sterling||January 1986||-17.96||39.12|
|Guatemala||A||C||U.S. dollar||December 1984||7.00||94.39|
|Guyana||A’||C||U.S. dollar||January 1991||99.59||85.65|
|Honduras||A||C||U.S. dollar||March 1990||0.00||165.00|
|Jamaica||A||C||U.S. dollar||January 1983||0.00||76.81|
|A||C||U.S. dollar||May 1989||0.1 1||26.62|
|Madagascar||A||C||French franc||June 1982||20.02||24.25|
|Pakistan||A||C||U.S. dollar||January 1932||0.00||29.90|
|Paraguay||A||D||U.S. dollar||January 1982||0.00||46.47|
|Trinidad and Tobago||A||C||U.S. dollar||April 1993||0.00||37.70|
|Yemen, Rep. of||A||C||U.S. dollar||November 1983||0.00||25.81|
|Zambia||B||D||Composite||October I98S||11.86||199.77|Figure A1Exit Cases Each Year
It is, however, possible to compare countries exiting from a peg with two control groups of countries: those that continued to peg without exiting, and other developing countries in the World Bank database aside from our exit cases.
Continuing peggers correspond to countries with lasting pegged exchange rate regimes between 1977 and 1996 (we accepted countries with occasional adjustments of the level of the peg). By examining the IMF’s sources described above, we identified 51 such countries (of which 36 were already in Frankel and Rose’s (1996a) database). For five of the variables examined, we included information for the period 1977–95: output growth, inflation, real interest rate, export value growth, and import value growth. For the remaining variables, we only included information for the period 1977–92.
Nonexits correspond to the data available in Frankel and Rose’s (1996a) database for the period 1977–92, excluding the exit cases in the above sample, and adding data for 1993–95 for five of the variables under examination: output growth, inflation, real interest rate, export value growth, and import value growth.
Figures A2–A5 summarize the behavior of the relevant variables centered on the month or year of the exit.41 In each case, the observations for the exit cases are surrounded by two-standard-deviation bands for the estimated average.
Figure A2.Exchange Rate Indicators
1The base of the index is 100 for the month prior to exit.
2Volatility is measured as the standard deviation of the monthly growth rate of the exchange rate over the last three months, averaged across exit cases.
Figure A3.Macroeconomic Indicators Figure A4Exchange and Trade Restriction Indicators
1The restriction index for a given country takes the value of one if there are payment restrictions and lero if there are no payment restrictions (as reported in International Monetary Fund. Annual Report on Exchange Arrangements and Exchange Restrictions)
Figure A5External Debt and Other Indicators
The exchange rate indicators in Figure A2 suggest that exits are typically preceded by gradual nominal and real appreciation and followed by a step depreciation (and in the case of the nominal exchange rate by some further depreciation over time). Thus, though the definition of exits includes in principle both cases of appreciation and depreciation, in fact, the latter have dominated (see Table A3). Real and nominal exchange rate volatility jump up around the lime of the exit. Both remain an order of magnitude higher than before for several months after the event.42
Figure A3 suggests that exits have not been happy events. Typically, economic growth has slowed in the period leading up to the exit. In the year of the event, growth is actually negative, and significantly below that in both the nonexit cases and in countries with lasting pegs. The growth of exports (measured in current dollars) also slows, falling significantly below that in both control groups in the year preceding the exit. Subsequent to the event, output and exports recover.43 Logically, exports respond first to the change in the exchange rate; in contrast, output growth only begins to revive in the second post-exit year.
In the case of inflation and money growth, the choice of control group is important. Both variables are typically higher both prior and subsequent to exits than in countries with lasting pegs, since countries with lasting pegs have by necessity brought their inflation and money growth rates down to the levels prevailing in the industrial countries to which they peg. In contrast, inflation and money growth are significantly lower around the time of exits than in all nonexit cases, the alternative control group being dominated by high-inflation countries with floating rates. These contrasts suggest that countries that have exited from pegs have typically been less successful in bringing inflation and money growth down to the levels of the industrial countries to which they peg than have been countries with lasting pegs. But countries that have opted for pegs, temporary as well as lasting ones, have a preference or an ability to maintain relatively low rates of inflation. In other words, although inflation generally rises following an exit, countries that exit from pegs continue to run lower rates of inflation even after their move to greater flexibility than countries with longtime floating rates.
Three additional macroeconomic indicators, the government budget deficit, the current account deficit, and international reserves, behave as predicted by models of balance of payments crises: countries that exit have relatively large budget and current account deficits in the years leading up to the exit, and they tend to lose international reserves (measured in months of imports). But neither the budget, nor the current account, nor the level of reserves differs significantly from those for peggers or those for the entire group of nonexiting countries. Similarly, an indicator of the condition of the banking system (liquidity as measured by the ratio of liquid reserves to total assets) is little different in the exit cases from either control group of countries.44
The panels for the incidence of current and capital account restrictions, also in Figure A4, are striking. Countries that exit from pegged rates have a significantly lower probability of having maintained capital account restrictions in the period leading up to the event. This result should be regarded with caution, for there is reason to worry that the information on which it is based is subject to serious limitations.45
But we cannot rule out the possibility that countries that have undergone capital account liberalization tend to voluntarily opt for more flexible rates in order to better manage their exposure to international capital flows.46 Another interpretation is that countries with open capital accounts are more susceptible to being forced off their pegs.47
Figure A5, which considers various indicators of the external position, is consistent with this interpretation that exits historically have been forced on countries with a fragile external position. Countries that exit from their pegs tend to have more debt than the control group cases and to receive less inward direct foreign investment. They tend to have more variable rate debt than countries with lasting pegs.48 Thus, the composition of the capital account suggests external fragility on the part of countries that are forced or choose to exit from their pegs.
On average, then, exits from pegged exchange rates have not occurred under favorable circumstances. They have not had happy results in the short run. Countries have generally waited to exit until reserves are falling. Exits have been associated with disappointing economic growth, both before and after the fact, and with disappointing export performance in the preceding period.
For over a decade Chile’s exchange rate policy has followed a relatively smooth process of gradual adaptation to changing conditions (Table A4). This process began after a turbulent period in the early 1980s, characterized by a balance of payments crisis, a severe recession, and a collapse of the banking system.49 A 15 percent devaluation in June 1982— which marked the end of an exchange-rate-based stabilization that failed to achieve rapid convergence of domestic inflation to industrial country levels— was followed by several turns in exchange rate policy: after the devaluation, the peso was linked to a basket of currencies and an exchange rate schedule covering the following 12 months was announced, only to be abandoned in August 1982, when the peso was allowed to float. A crawling peg was adopted in September of that year, but it was accompanied by several discrete devaluations. In June 1985, Chile adopted a system of crawling exchange rate bands.50
|Exchange Rate Regime||Financial Reforms and Instruments||Situation of Banking System||Exchange System|
|Type of regime||Manner exit cook place||State of reforms||Monetary instruments||Type of problem||Extent of problem||Current account||Capital accounc|
|Crawling peg— backward looking, September 1982-August 1984.|
Crawling peg— backward looking (±0.5 percent band), August 1984-May 1985.
Crawling peg— backward looking (±2 percent band). June 1985-December 1987.
Crawling peg— backward looking (±3 percent band), January l988-june 1989.
Crawling peg-backward looking (5 percent band july 1989-December 1991
Crawling peg— backward looking (± 10 percent band), January 1992— January 1997.
Crawling pegbackward looking (± 12.5 percent band), February 1997-present.
|Smooth: switch to crawling peg with very narrow band.|
Smooth: switch to wider band to increase flexibility.
Smooth: switch o t wider band to improve competitiveness.
Smooth: switch t o wider band to improve competitiveness.
Smooth: switch t o wider band, in part to deal with persistent large capital inflows.
Smooth: switch o t wider band to discourage speculative inflows. In July 1992 moved to basket peg; in 1992-94 some step revaluations.
|Bold financial reforms took place in 1974-78. Measures included privatization of commercial banks, lowering of barriers to entry for domestic banks and financial institutions and branches of foreign banks, and easing of restrictions on the scope of their activities and borrowing abroad.|
The banking crisis of 1981-87 caused a reversal of some of the reforms. The soundness of the financial system improved after 1987, and a steady deepening of financial markets has continued. The central bank gained independence in October 1989.
|Ability of the central bank to implement monetary policy was hampered by the banking crisis in 1981-87. Interest rate liberalization reform was reversed until 1987.|
From 1987, the central bank increased its reliance on indirect monetary instruments. Currently, the main instrument of monetary policy is open market operations in central-bank-indexed promissory notes of various maturities, supplemented since 1990 (due to heavy capital inflows) with other instruments (reserve requirements, foreign currency swaps).
|Banking crisis (1981-87).|
No banking problems observed in the last decade.
|Insufficient preparation for financial liberalization (with inadequate supervisory powers, banks' lack of expertise in dealing with new credit and market risks, inadequate legal and accounting frameworks and prudential regulations) was associated with rapid credit expansion (total banking sector credit to private sector grew from about 20 percent of GDP in 1977 to 82 percent of GDP in 1982). Combined with high interest rates and several adverse external shocks, and the floating of the peso in 1982, imprudent bank behavior led to accumulation of bad loans and ended with a major banking crisis with runs on deposits.|
Nonperforming loans were estimated at 19 percent of total loans in end- 1983. Fourteen out of 26 private domestic banks and 8 out of 17 private domestic finance companies were intervened. The central bank purchased substandard loans to help recapitalize banks through 1987. A comprehensive restructuring of the banking system started in 1983 and was successfully implemented with far- reaching reforms in the banking sector, although it was slow and costly. Estimates of accumulated cost of the banking crisis range from 28 percent t o 41 percent of GDP.
Chile now has a well-developed banking sector. The ratio of nonperforming loans has been steadily declining, from 1.8 percent in 1990 to less than I percent in early 1996.
|Article VIII status was accepted in July 1977.|
Foreign exchange market was further liberalized in the 1990s and alltransactions were permitted unless specifically prohibited by the central bank. Parallel foreign exchange market became an informal legal market, where the exchange rate was determined freely.
|Since 1985, Chile has adopted a selective and rather gradual approach to capital account liberalization, with some acceleration n the 1990s.|
i Inward capital transactions had been generally free of restrictions until the early 1990s, while some outflows had been restricted. Chile reintroduced some restrictions on inflows (direct and price-based measures) in the 1990s, while progressively removing some of the restrictions on outflows to deal with a surge in capital inflows. It also used financial and prudential type regulations to influence capital flows, including modifications in reserve requirements.
The crawling band system remains in place today, although it has been modified gradually in response to a changing external environment and a shift in policy objectives. In general terms, the system consists of a central parity that is adjusted in line with the difference between past inflation and an estimate of world inflation, and parallel bands around the central parity. Band width was set at ±2 percent originally, and it has been widened several times since then.5l In November 1995, a real appreciation of 2 percent was built into the formula to compensate for faster productivity growth in Chile than in trading partners. In addition, on several occasions there have been discrete devaluations and revaluations of the central parity.
Two different periods can be distinguished in Chile’s experience with exchange rate bands: 1985–89 and the period starting in 1990.52 During the first period, exchange rate policy was largely aimed at restoring the losses of competitiveness accumulated since the late 1970s, in the context of a tight external constraint. Through several realignments (devaluations), widening of the band on two occasions, and with the exchange rate positioned near the upper (weaker) limit of the band most of the time, the system of crawling bands permitted the achievement of a 33 percent real depreciation in effective terms between 1985 and 1988.53 However, the pursuit of a competitive real exchange rate prevented a reduction of inflation to single digits, and inflation fluctuated between 15 percent and 30 percent (Figure A6). Control over the inflation rate was not lost mainly because Chile managed to maintain a very tight fiscal stance. A deficit of 3 1/2 percent of GDP recorded in 1985—largely the result of the crisis of previous years—was reduced gradually, and by 1988 Chile was recording sizable budget surpluses and had managed to reverse an upward trend in the external public debt ratio to GDP. At the same time, the current account deficit was lowered from 8 1/2 percent of GDP to near balance. In 1988, in anticipation of a national referendum—and subsequently of the first elections to be held in Chile in nearly two decades—macroeconomic policies were relaxed and, as a result, inflation picked up, the real exchange rate appreciated, and the current account deficit widened for the first time in five years.
Figure A6Chile: Selected Macroeconomic Indicators
Sources: International Monetary Fund, Internatjonat Financial Statistics, Information Notice System, and Wortd Economic Outlook; and IMF staff estimates.
1In percent of GDP
The second period is characterized by a very different external environment and the reorientation of policy objectives. Chile no longer had a current account problem and, in the second half of 1990, a long period of limited capital mobility came to an end abruptly as the country resumed access to international capital markets. International investors, who were beginning to devote attention to emerging markets, found Chile attractive, especially given its high domestic interest rates, which reflected an important change in policy objectives. In 1989 the central bank had been granted legal independence and had been entrusted with the explicit objective of achieving price stability. Moreover, unemployment had declined steadily during the late 1980s and inflation was rising. In this context, the government gave increasing attention to the goal of lowering inflation and relatively less to the real exchange rate. To achieve these objectives white preserving the crawling band system, the authorities resorted, in addition to interest rate hikes, to discrete appreciations, widening of the bands, extensive sterilized intervention, and the use of capital controls.54 Although these policies did not prevent a real appreciation, they did succeed in reducing inflation to single digits while at the same time preventing the real appreciation warranted by market developments from leading to perverse dynamics in the current account.
As it was the case in the first period, it appears that a sound fiscal policy (budget surpluses were recorded throughout this period) played an important role in helping reconcile apparently conflicting objectives in the second period. An appropriate supervisory framework, implemented as part of the comprehensive restructuring of the banking system that took place in the 1980s, also ensured the smooth functioning of the banking system after 1990.
Israel fixed its exchange rate against the U.S. dollar as part of its July 1985 stabilization plan (Table A5).55 Since then, the exchange rate system has evolved gradually toward more flexible arrangements, to accommodate the authorities’ objective of providing the economy with a nominal anchor while at the same time preventing sizable appreciations of the real exchange rate that could lead to balance of payments problems. The currency was devalued in January 1987 and December 1988. In January 1989, the central bank introduced a ±3 percent horizontal band around the central parity. The parity was devalued four times between June 1989 and March 1991, and the band was widened to ±5 percent in March 1990. On December 17. 1991, following another discrete devaluation, a system of diagonal or crawling bands was introduced, with the slope of the bands determined as the difference between a target level for domestic inflation and a forecast of world inflation. Band width was originally kept at 5 percent, but was widened to ±7 percent on May 31, 1995, and in June 1997 by adjusting the limit on depreciation and the slope of the lower (appreciated) edge of the band. A small discrete devaluation was often introduced at the time of the announcement of the parameters of the new band.
|Exchange Rate Regime||financial Reforms and Instruments||Situation of Banking System||Exchange System|
|Type of regime||Manner exit took place||State of reforms||Monetary instruments||Type of problem||Extent of problem||Current account||Capital account|
|Fixed peg to U.S. dollar, July 1985-August 1986.|
Fixed peg t o basket, August, 1986-December 1988.
Horizontal band (±3 percent), January 1989— March 1990.
Horizontal band (±5 percent), March 1990-December 1991.
Crawling peg— forward looking (±5 percent band), December 1991-May 1995.
Crawling peg— forward looking (±7 percent band), June 1995-May 1997.
Crawling peg— forward looking (29 percent asymmetric band), (June 1997-present).
|Smooth: switch to basket peg on concerns about competitiveness|
Smooth: switch to horizontal band; more flexibility to deal with capital flows.
Crisis/Smooth: devaluation forced by the market, followed by a decision to widen the band to limit devaluation expectations.
Smooth: move to crawling band to allow periodic devaluation at a forward looking rate (to maintain ompetitiveness as anchoring inflation).
Smooth: to wider band to bring uncertainty and limit capital inflow. Smooth: to wider band to limit capital inflows.
|Until 1985, the financial system was characterized by heavy government intervention with its adverse effects on the efficiency and performance of the foreign exchange markets. From 1985, the authorities have undertaken substantial liberalization of the financial markets, operating on the premise that it was best to first remove domestic distortions and reduce restrictions on the current account before finally liberalizing the capital account.|
Deregulation measures implemented from 1987 included reduction in mandatory investment requirement for institutions such as pension funds and insurance plans; permission for nonfinancial firms, and t o a limited extent, commercial banks to issue bonds; and reduction in reserve requirements.
These reforms enabled a marked narrowing of interest rate differentials and a major reduction in the extent of government intervention in the economy.
|Israel has had an exchange rate-cum-inflation targeting framework in recent years (inflation targeting introduced n 1992); i implementation of monetary policy has been complicated by the substantial increase in capital inflows in attaining simultaneously the exchange rate and inflation objectives; emphasis on inflation targeting subsequently increased.|
The central bank affects the level of liquidity by managing the amount of bank reserves through its discount-window and regular monetary auctions.
|Significant banking problems in 1983-84.|
No problems in the banking sector in the last decade.
|Government nationalized some of the major banks accounting for 90 percent of the market; there had been a bank undercapitalization problem exacerbated by the stock market crisis.|
As part of the efforts to reform the financial system that started in the late 1980s, a banking sector reform was undertaken in 1993 aimed at increasing the degree of competition and reducing conflicts of interest in the Israeli financial system. A bank privatization program was also initiated in the early 1990s, and two small banks have been privatized, while there has been limited progress in the privatization of the major banks. The banking system is still highly concentrated, with three banks accounting for 80 percent of total banking business. There has also been some recent increase in the banking system loans t o the private sector, from about 55 percent in 1991 to 72 percent in 1996.
|Following a gradual easing of an extensive system of foreign exchange controls since 1985, Israel accepted Article VIII status in September 1993, achieving current account convertibility.||Following the current account convertibility in 1993, several steps have been taken toward achieving convertibility of the capital account.|
In general, Israel adopted I a more liberal approach toward nonresident than resident capital transactions in th e areas of financial credits and direct investment. Some resident transactions have also been liberalized, however; limits on direct investments abroad by Israeli companies were eliminated and regulations i n portfolio investments abroad by resident companies and institutional investors have been eased.
Despite substantial inflows of capital and the associated complications i n th e implementation of monetary policy, the authorities have resorted t o controls on short-term capital inflows in view of their experience with the ineffectiveness of such controls used in the 1970s, and their potential impact on allocation mechanisms.
The stabilization program led to an important reduction in inflation (Figure A7), but not to the level observed in trading partners and, as a result, the real exchange rate appreciated considerably. In this context, the devaluations of 1987 and 1988 came only after considerable losses in competitiveness had accumulated. Thus, in order to prevent further losses in competitiveness and reduce the variability of the real exchange rate, the authorities adopted the horizontal band. The various realignments of the central parity of the horizontal band indicated above did stabilize the real exchange rate,56 but there were no further gains in disinflation during this period: inflation fluctuated between 16 percent and 20 percent from 1987 to 1991. The fiscal situation had worsened, as the surpluses recorded in 1985–86 vanished, and by 1989 a deficit of nearly 6 percent of GDP was recorded. A moderate deterioration of the current account balance also took place.
Figure A7Israel: Selected Macroeconomic Indicators
Sources: International Monetary Fund, International Financial Statistics, Balance of Payments Statistics Yearbook, Wortd Economic Outlook, and Information Notice System; Organization for Economic Cooperation and Development, External Debt Statfetks; and IMF staff estimates.
1In percent of GDP
2Index 1990= 100
The frequency of devaluations (four in less than two years) of the parity of the horizontal band led to an increase in interest rate volatility as markets began to anticipate, and possibly also precipitate, the subsequent devaluation. This fact, coupled with the recognition by the authorities that they were not pursuing a fast convergence of domestic inflation to the levels observed in partner countries, led the central bank to adopt a crawling band. As a byproduct of the band, the central bank also adopted explicit inflation targets. The move to a crawling band did lead to lower interest rate volatility and an improved inflation performance.57 However, in spite of robust growth throughout this period, there was only a temporary adjustment of the fiscal accounts in the early 1990s, followed by worsening later.
Although various measures aimed at deregulating the domestic financial system and relaxing restrictions on capital movements were implemented (with some reversals) in the 1970s and 1980s, net capital inflows were not significant until the 1990s, when there was a further move toward capital account liberalization. The presence of large capital inflows in the context of a lax fiscal policy has led to a real appreciation and a widening current account deficit in recent years. Nevertheless, Israel’s policy of moving gradually to more flexible exchange rate arrangements following an exchange-rate-based stabilization has functioned relatively well. The authorities have managed to reduce inflation, albeit slowly and to levels that are still high in relation to those observed in industrial countries, while preventing the development of significant balance of payments problems. They intend to remove all remaining capital account restrictions in the course of 1998.
The crisis in Mexico in 1994–95 involved a sudden exit from a currency commitment that involved generalized loss of investor confidence and severe real and financial costs (Table A6). This occurred despite the fact that the exchange arrangement before the crisis was a crawling band that already had a degree of nominal flexibility. However, in 1994 it became a one-sided bet as the exchange rate moved to the most depreciated edge of the band, and stayed there persistently.
|Exchange Rate Regime||Financial Reforms and Instruments||Situation of Banking System||Exchange System|
|Type of regime||Manner exit took place||State of reforms||Monetary instruments||Type of problem||Extent of problem||Current account||Capital account|
|Fixed peg to the U.S. dollar, February 1988-end-1988.|
Preannounced crawling peg, January 1989-November 1991.
Preannounced crawling band, November 1991-December 1994
|Smooth: switch to preannounced crawling peg as inflation fell to introduce greater flexibility to the exchange rate in dealing with real appreciation and capital flows.|
Smooth: switch to preannounced crawling band with gradually widening band width (fixed floor and crawling ceiling) to resolve tensions between competitiveness and disinflation goals. In reality exchange rate was kept mostly within a narrow inner band by intramarginal intervention.
Crisis: devaluation of the band ceiling, followed by a float as pressures on the peso continued.
|In 1982-88, the financial system was quite regulated. Major reforms took place in 1988-91, with deregulation of interest rate and credit controls, elimination of reserve requirements and liquidity ratios, and bank privatization. The number of banks increased (from 20 to 35), while foreign participation in the financial sector increased only in 1995. Financial deepening was helped by the stabilization efforts.|
Following the banking crisis in 1994, a restructuring scheme for loans denominated in foreign currency was established. Banking supervision procedures and methodologies have been improved and prudential regulations were tightened.
|Treasury-bill auctions were introduced in 1978 with a view to using certificates of treasury (Cetes) as indirect monetary policy instrument. Since then, operations in primary and secondary markets for public debt (Cetes and indexed bonds) became the main instruments of monetary policy. Intervention in the secondary market (with repo and reverse repo agreements) and credit auctions supplemented open market operations.|
Under the current floating regime, monetary policy is exercised through open market operations, credit auctions, and the pricing of bank overdrafts with the central bank.
|Banking crisis (1994-present).||Inadequate preparation for financial liberalization (supervisory shortcomings and banks' lack of experience prior to privatization) led to an overextension of Mexican banks in the liberalized world of the l990s. Total banking system credit to private sector rose in 1988-94 from 10 percent to about 40 percent of GDP. Financial liberalization and strengthening of public finances resulted in a shift of lending in favor of riskier borrowers. Intensive process of bank privatization, preferential credit access to some bidders, the overpricing of bank assets, and weak legislation against concentration of ownership allowed a few large businesses to acquire a large part of the financial system.|
Banking problems started in late 1992, but signs of increasing fragility became clear from early 1993 with insufficient capitalization and inappropriate provisioning against a rapid accumulation of bad loans and deteriorating asset quality. The ratio of nonperforming loans in total loans rose from about 4 percent in 1991 to 7.3 percent in 1993, 8.3 percent in September 1994, and 12 percent in end-1995, excluding the loan portfolios acquired by the deposit insurance agency. The sharp exchange rate depreciation, increase in interest rates, and downturn of the economy following the 1994-95 currency crisis diminished debtors’ ability to repay and contributed to the liquidity and solvency problems of many financial institutions.
More than half of the banks received some financial support from the government. In 1994-96, eight banks were intervened and two were taken under the administration of the deposit insurance agency. The overall cost of bank support is estimated by the government at 11.9 percent of GDP.
|Article VIII status was accepted in November 1946, with all restrictions on payments and transfers for current international transactions eliminated.||Foreign exchange controls were abolished in 1991. No exchange controls were introduced during o r following the currency crisis in end-1994.|
Some restrictions, however, still exist on certain transactions. These concern extension of financial loans from commercial banks, respecting foreign currency position limits, foreign direct investment in certain priority sectors, and purchase abroad of money market and capital market securities by resident securities firm s on their own account and on the account of their clients.
Following a period of occasional speculative pressures during 1994, on December 20 the Mexican authorities widened the band by devaluing its upper edge against the U.S. dollar by 15 percent and subsequently abandoned the crawling band mechanism that had been in effect since November 1991. The decision was taken against the background of continued market pressures, which had reduced the reserves of the Bank of Mexico to unsustainable levels, and fragility of the banking system, which had made raising interest rates an unviable option to defend the band.
The float marked a significant change in Mexico’s long-standing policy of employing fixed exchange rates in its stabilization efforts. Prior to the late 1980s, the Mexican authorities had adopted many different forms of a pegged exchange rate system, ranging from a pure peg to a preannounced crawling peg, alternating with brief periods of floating rates that followed episodes of balance of payments crises. From 1988 onward, however, Mexico followed a strategy of gradually adapting exchange rate policy to changing economic conditions and policy objectives. The authorities fixed the U.S. dollar exchange rate in early 1988, replacing it with the crawling peg mechanism in 1989, and moved to a gradually widening crawling band in November 1991. In doing so, the authorities attempted to combine nominal anchoring with sufficient exchange rate flexibility to maintain competitiveness while keeping inflation low, in the face of strong inflows of capital since the late 1980s, In practice, however, the Bank of Mexico did not use the flexibility offered by the band and conducted intramarginal intervention to keep the peso within a narrow inner band until early 1994.
Unlike previous currency crises in Mexico, the crisis of 1994–95 took place in the context of a broadly favorable macroeconomic environment following the authorities’ adoption of a comprehensive anti-inflation strategy in 1987 (Figure A8). Because of restrictive monetary and fiscal policies, a stable exchange rate supported by tight wage policy, and the liberalization of the trade and financial systems, economic growth picked up, inflation was reduced to single digit levels, fiscal accounts and public debt improved markedly, and external debt was reduced to more sustainable levels. By 1993, the peso was somewhat overvalued and the current account deficit was widening, but there was growing confidence in the economy since the deficit was being covered by strong inflows of capital. The fact that a significant part of the inflows was short term was to be the source of future problems. Dollar-denominated and short-term components of the external debt also rose, with the largest proportional increase reflecting a rise in nonresident holdings of dollar-linked nea-sury bills (Tesobonos),
Figure A8Mexico: Selected Macroeconomic Indicators
Sources: International Monetary Fund, International Financial Statistics, Information Notice System, and World Economic Outiook; United Nations, Monthly Bulletin of Statistics; and IMF staff estimates.
1In percent of GDP
2Index 1990 = 100
In addition, deregulation of the financial system was undertaken without adequate preparation, with supervisory powers and commercial banks lacking the necessary expertise and tools to assess credit and market risks and to monitor lending. As a result, banking sector credit expanded substantially and asset quality deteriorated rapidly. Signs of increasing fragility became apparent from late 1992 and played a critical role in the authorities’ failure to respond with sufficiently higher interest rates to the exchange market tensions during 1994, which were triggered by a number of adverse domestic and externa) shocks. These tensions caused a shift in market sentiment, and loss of confidence was amplified by the surprise announcement of a devaluation of the band in December 1994. Given the short term and speculative nature of the capital inflows, there was a substantial flight of capital out of Mexico as maturing government debt was not rolled over. Continued selling pressure on the peso and the subsequent crisis in the foreign exchange market was followed by a severe banking crisis, exacerbated by the sharp depreciation of the peso, the downturn in economic activity, and sharply higher interest rates. More than half of the Mexican banks received financial support from the government, and a bank restructuring program was put in place in early 1995.
It is noteworthy that exchange market tensions did not cease with the floating of the peso, which lost more than half of its value over a period of a year. Although there is little disagreement on their role in the crisis, the deterioration in Mexico’s economic fundamentals did not seem to justify the size of the exchange rate depreciation that occurred. It seems that the sudden loss of confidence following the devaluation may have stoked self-fulfilling fears of an imminent default on short-term debt (given the low level of reserves), a collapse of the banking system, and a spiraling depreciation of the peso.58 The confirmation of the availability of adequate external financing and a comprehensive program put in place by the authorities (including a bank restructuring strategy) helped restore investor confidence, but only gradually. The Mexican experience is important in demonstrating that the implementation of significant reforms and maintaining prudent fiscal policies are not sufficient to ensure the sustainability of large external imbalances in a liberalized financial system, unless such prudence is accompanied with a healthy financial system, as well as with timely and adequate policy responses to shocks.
The Polish experience with exchange rates since 1990 is an example of a timely and flexible adaptation of exchange rate arrangements to changing economic conditions (Table A7). It also demonstrates that exchange rate policy cannot, and should not, be viewed in isolation, and should be accompanied by financial, incomes, and structural policies that are consistent with it.
|Exchange Rate Regime||Financial Reforms and Instruments||Situation of Banking System||Exchange System|
|Type of regime||Manner exit took place||State of reforms||Monetary instruments||Type of pro bi err.||Extent of problem||Current||Capital account|
|Fixed peg to U.S. dollar, January 1990- May 1991.|
Fixed peg to basket, May 1991-October 1991.
Preannounced crawling peg, October 1991-May 1995.
Preannounced crawling band (±7 percent band), May 1995-present.
|Smooth: devaluation and move to basket peg to restore competitiveness given the still high inflation differentials.|
Smooth: switch to preannounced crawling peg to curb real appreciation while anchoring inflation with a forward-looking crawl.
Smooth: move to crawling band: a compromise between competing goals of disinflation and competitiveness, made even harder with persistent capital inflows. The band aimed at allowing for market-driven appreciation.
|Financial reforms took place from 1990 in the context of Poland’s transformation from a centralized economy to a market economy.|
Interest rates wer e deregulated in 1990. Banking system reform and privatization were initiated in the early 1990s. Four out of nine state-owned banks were privatized. Share of private banks rose to 30 percent of total assets of the banking system and to 40 percent of capital. Banking system is still somewhat concentrated (five banks own 5 0 percen t of assets).
A treasury bill market was established early in the reform process. Improvement in the payments system led to a rapid development of the money market and establishment of benchmark market- based interest rates.
A new central bank law, which will strengthen the central bank independence, is under discussion.
|From a system of (informal) credit ceilings for state- owned banks, Poland moved to indirect monetary instruments in 1990-91.|
Open market operations have been the primary instrument since 1993. For most banks, interbank and treasury bill rates are key benchmark rates for pricing loans and deposits. Early development of indirect instruments enhanced credit allocation process and encouraged financial intermediation.
Fixed exchange rate policy and capital account liberalization, however, have brought challenges to monetary policy, and maintaining independence of monetary policy required heavy and costly sterilization.
|Significant banking problems (1991-95) with no major banking crisis.||Lax entry policy to banking system during financial liberalizatio n le d to substantial growt h in bank lending, deterioration in asset quality, and bank insolvencies in the earl y 1990s. Total bank credit to private secto r rose from 1.7 percent of GDP in 198 9 to 12.2 percent of GDP in 1993 (particularl y strong in 1990-91). About 16 percent of bank loans were classified as lost, 22 percent as doubtful, and 24 percent as substandard in 1991.|
Liquidity support to banks was provided by the central bank in 1993-94. Bonds issued to recapitalize problem banks amounted to 2 percent of GDP in 1993-94. Accumulated cost of bank support was estimated to be at 5.7 percent of GDP. Government assistance was tied to a comprehensive program of restructuring public banks and enterprises. Prudential regulations have been established and supervisory capacity has been strengthened. State banks have unlimited deposit guarantee through 1999. Limited deposit insurance was introduced for other banks in 1995.
The restructuring program has been largely implemented successfully, which enabled bank profits and solvency to improve rapidly. The ratio of bank loans classified as lost, doubtful, and substandard declined to 11.8 percent, 3.4 percent, and 5.2 percent, respectively, of total portfolio in 1995, and further to 8.4 percent, 1.7 percent, and 3.9 percent, respectively, by September 1996. The overall ratio of nonperforming loans in total portfolio fell from about 31 percent in 1993 to 14 percent in September 1996.
|ArticleVIII status was accepted in June 1995, although exchange system had been substantially liberalized at the outset: multiple exchange rates were unified, and restrictions on foreign exchange were eliminated in 1990-91. The parallel market was legalized in 1989.||Poland has substantially liberalized its capital account restrictions since the beginning of the reform.|
Regulations on foreign direct investment were liberalized in July 1991. Full repatriation of portfolio investments in the stock and government securities markets were allowed i n July 1991 and July 1993, respectively. Faced with a surge in capital inflows from 1994, some controls on capital outflows were further relaxed.
Some approval requirements remain for inflows and outflows concerning money market instruments, derivatives, short-term financial credit operations between residents and nonresidents, and outward direct investments (to some countries).
In 1990, Poland embarked on a comprehensive reform program with a view to stabilizing the economy and to putting it on the transition path to a market economy. Monetary, fiscal, and incomes policies were tightened, the foreign exchange market was substantially liberalized, most restrictions on capital transactions were abolished, and a comprehensive set of financial reforms was implemented, including the freeing of interest rates and deregulation of the banking system. As a result, inflation was reduced substantially with a remarkable growth performance, imbalances in the external account were substantially eliminated, and external debt was reduced markedly. The success of Poland’s overall macroeconomics policy has been attributed to a “multiple-anchor, multiple-indicator” change rate, interest rates, fiscal and incomes policies, and structural reforms all playing a major role.
Within this strategy, exchange rate policy has played a dual role, acting both as an inflation anchor and responding as well to developments in international competitiveness. The zloty was initially fixed against the U.S. dollar to brake hyperinflationary pressures, while the parity was set at a level that would restore and maintain competitiveness. The currency was then pegged to a basket in May 1991, to address the continued loss of competitiveness in view of the still high inflation relative to trading partners. Further flexibility was introduced in October 1991, when the regime was modified to a preannounced crawling peg as deterioration in competitiveness persisted; the anchor role of the exchange rate was maintained, however, by choosing an “active” crawl that allowed the currency to depreciate at a rate smaller than the projected inflation differentials. Flexibility of the exchange rate was further advanced in May 1995 when the authorities decided to allow a market-driven appreciation within a formal crawling band of ±7 percent around a central parity. This system would maintain partially the anchor role for the exchange rate, while at the same time providing a scope to deal with various shocks and capital flows.
Although the Polish approach to monetary and exchange policy has so far served the country well, the authorities have had to deal with tensions associated with trying to attain the competing goals of competitiveness and disinflation. In order to address the competitiveness problem, Poland moved progressively toward more flexible variants of “fixed” exchange regimes (as described above), as well as allowing for step devaluations (three devaluations in 1991–93). The pass-through of the resulting depreciation to inflation was reduced by choosing an “active” crawl that allowed for less-than-perfect accommodation of inflation differentials; the rate was also reduced successively (in five steps in 1991–96). More important, exchange rate policy was complemented with additional anchors, including tight fiscal and (tax-based) incomes policies, which helped alleviate pressures on both inflation and competitiveness.
Implementation of monetary policy has been further complicated by a substantial increase in capital inflows since 1994 against the background of rising domestic interest rate differentials and liberalization of the capital account. Continued need to progress in disinflation required higher domestic interest rates, but the latter stimulated further inflows, risking a loss of control over monetary aggregates and inflation. As sterilization of these inflows became increasingly difficult and costly, the authorities used further reductions in the crawl rate and relaxed most controls on capital outflows. Faced with continued inflows, they increased the flexibility of the exchange rate through a switch to the crawling band regime; as in Mexico, however, the band has not been used much in practice, except for a few small step appreciations and a reduction in the crawl rate. The authorities finally adhered to interest rate reductions as the cost of sterilization became a serious policy concern; lower interest rates, however, caused a recent acceleration in domestic credit expansion, and interest rates have been increased since Sate 1996 (Figure A9).
Figure A9Poland: Selected Macroeconomic Indicators
Sources: International Monetary Fund. International Financial Statistics, World Economic Outhok, and Information Notice System: United Nations, Monthly bulletin of Stmistjcs; and IMF staff estimates.
1In percent of GDP
2Index 1990 = 100
Poland’s banking system was also not free of troubles. In fact, similar to the experiences of several of the other countries discussed in this section, insufficient preparation for liberalization had resulted in a sharp increase in bank lending and a subsequent deterioration in loan quality. Banking system problems were managed without a subsequent crisis, however, as the government support to problem banks was successfully tied to a comprehensive program of bank restructuring. Prudential regulations and supervisory capacity have also been strengthened. As a result, the situation in the banking sector stabilized, with a substantial improvement occurring in the ratio of nonperforming loans.
After more than a decade of exchange rate stability, the Thai baht came under severe speculative pressure in May 1997, forcing the authorities to impose controls on international capital transactions (Table A8). Despite heavy intervention by the Bank of Thailand and significant intervention support provided by the regional monetary authorities, the pressure on the baht did not subside, and on July 2, 1997. the authorities abandoned the policy that had been in effect since November 1984, of pegging the baht to an undisclosed basket of currencies (dominated by the U.S. dollar). The decision to float was taken against the background of growing concerns about Thailand’s economic fundamentals, a sharp fall in official reserves, and concerns about the adverse effects of a required increase in interest rates on a fragile economy and financial system. By early October 1997, the baht had depreciated by about 30 percent and financial markets had not yet calmed down despite the announcement of an emergency financing package with the IMF. The turmoil also spilled over quickly to several other Asian currencies, forcing their authorities to adopt more flexible exchange rate regimes.
The crisis in Thailand occurred despite an impressive record of economic growth over more than a decade (Figure A10). The authorities’ commitment to macroeconomic stability, prudent financial policies, and increasingly open trade and financial systems had contributed to strong economic performance, as evidenced by single-digit inflation rates, improved fiscal accounts, and a marked decline in its public debt since the late 1980s. There were growing signs of overheating in the economy after 1994, however, despite tight financial policies followed by the authorities, as inflation picked up and the current account deficit widened significantly; the latter in part reflected Thailand’s loss of competitiveness brought about by the baht’s close link with the appreciating dollar. While the deficit was more than financed by strong inflows of capital, a growing component of these inflows (about 60 percent) was short term. Access to short-term foreign capital had been facilitated by capital account liberalization since 1993, including the opening of the Bangkok International Banking Facilities. The rising share of short-term external debt made the continued financing of Thailand’s large external imbalance vulnerable to a sudden shift in market sentiment.
The growing size and volatility of these inflows also complicated the implementation of monetary policy in an environment of a fixed exchange rate, an increasingly open capital account, and scarcity of indirect monetary instruments. The authorities attempted to manage these inflows with a combination of monetary and prudential measures, and later with some price-based controls. They refrained from further liberalization of the capital outflow controls or from allowing greater flexibility in the determination of the exchange rate, which could have helped discourage speculative inflows and put downward pressure on inflation.
Similar to the experiences of Mexico and Poland, the liberalization of the financial system in Thailand was associated with a rapid expansion in lending. A growing number of finance and securities companies increased their exposure to the real estate sector and provided foreign currency loans to borrowers who were only partly hedged in an environment secured by apparent exchange rate stability. This expansion in turn led to a gradual deterioration in asset quality. As the markets started in 1996 to observe growing indications of the solvency and liquidity problems encountered by several finance and securities companies, the authorities’ lack of transparency in disclosing data on their financial situation precipitated market fears that the health of the financial system was much worse than had so far been apparent. In the event, a significant number of institutions were asked to suspend operations, several to merge with stronger partners, and some to increase their capital in the aftermath of the baht’s float. The authorities provided emergency liquidity to the financial system and subsequently adopted a comprehensive restructuring strategy.
|Exchange Rate Regime||Financial Reforms and Instruments||Situation of Banking System||Exchange System|
|Type of regime||Manner exit took place||State of reforms||Monetary instruments||Type of problem||Extent of problem||Current account||Capital account|
|Fixed peg to U.S. dollar; 1950-November 1984.|
Fixed peg to an undisclosed basket, November 1984-July 1997.
|Smooth: a devaluation, followed by a switch to an undisclosed basket peg to correct for competitiveness loss; there were no runs on reserves.|
Crisis: switch to managed float following massive and persistent speculative pressures on the baht.
|The financial system was characterized by heavy concentration and lack of competition in the early 1980s. Financial sector reform in 1986-89 aimed at enhancing competition and efficiency of banks and developing an interbank money market.|
Interest rate ceilings and controls on deposit and lending rates were lifted in 1989-92; finance companies wer e allowed to conduct new services and entry rules were relaxed during th e 1990s. The depth of the financial markets has risen steadily. The banking system has developed but is concentrated (six banks account for three-fourths of total bank deposits). Banks are subject to capital adequacy requirements in line with Bank for International Settlements rules. Provision requirements against doubtful loans were raised to 100 percent from 70 percent in end-1995.
|Effectiveness of interest rate and monetary aggregates (money supply, bank lending, etc.) as monetary control instruments were reduced with progressive financial and capital account liberalization. Use of indirect monetary policy instruments is limited, though there had been recent intentions to improve the flexibility and effectiveness o f monetary management through market-based instruments. The central bank relied on foreign exchange swaps to manage liquidity effects of capital inflows, which involved setting a forward rate that in the context of fixed exchange rates did not deviate significantly from the spot rate.||Banking crisis (1983-87).|
Financial system crisis (early 1990s-present).
|In part owing to rapid credit growth and subsequent slowdown in economic activity, the banking system experienced severe problems. There wer e bank runs durin g 1983-85. Twenty-five institutions were closed, 9 merged, and 18 supported, with more than 25 percent of financial system assets affected. About 15 percen t of bank assets were nonperforming. Efforts began to strengthen bank supervision and deal with weak financial institutions.|
Substantial short-term capital inflows were associated with a rapid growth of lending to private secto r (high exposure to real estate sector and foreign currency loans to unhedged borrowers), and a subsequent fall in loan quality. Since 1996, there were indications that the financial system faced severe solvency and liquidity problems: the ninth largest bank collapsed in 1996 and the government stepped in to protect depositors; local deposit s shifted from commercial banks to foreign bank branches; in December the central bank announced that nonperforming loans were 8.4 percent of banking system loans in September 1996 (up from 6.9 percent in end-1995); in earl y 1997 a finance company merged with a small bank, with rumors of a run o n its deposits; the central bank asked 10 finance companies to increase their capital. Since June, the government decided to close 58 of the 91 finance companies to save healthy companies and prevent a crisis o f confidence. The central bank spent B 500 billion in emergency liquidity to the financial sector and subsequently adopte d a bank restructuring strategy following th e financial crisis.
|Article VIII status was accepted in May 1990, eliminating all restrictions on payments and transfers for current international transactions: there is. however, a remittance tax on transfers abroad of profits, interest, and other income that gives rise to multiple currency practice subject to IMF approval.||In l989–96, Thailand followed a more liberal approach toward nonresidents than residents for transactions in capital and money market securities, financial credits, direct investment, and commercial bank transactions. Authorities tried to manage high and volatile inflows with a combination of monetary and prudential measures: while most outflow controls were also eliminated, central bank approval was required for certain resident transactions.|
Some restrictions were imposed during 1996 and a two-tier system was introduced in mid-1997 to cut supply to offshore speculators. In June, prohibition of certain foreign exchange transactions with foreign financial institutions were formalized. On August 19.1997, it was announced that controls will be maintained until markets are stabilized.
Figure A10Thailand: Selected Macroeconomic Indicators
Sources: International Monetary Fund, International Financial Statistics, Information Notice System, and World Economic Outlook; United Nations, Monthly Bulletin of Statistics: and IMF staff estimates.
1In percent of GDP
2Index 1990 = 100
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For an introduction to this literature, see Wickham (1985); Aghevli, Khan, and Montiel (1991); Frenkel, Goldstein, and Mas-son (1991); and Mussa and others (1994). Appendix I reviews the main conclusions of this literature.
Trade is a comparatively small share of GDP for both the United States and Japan. For Germany, the trade share is large, but most of this trade is with countries that peg their currencies tightly to the deutsche mark. Germany would be much less comfortable with a floating exchange rate (as would its European partners) if the deutsche mark fluctuated against other European currencies with anything near the volatility exhibited against the U.S. dollar and the Japanese yen.
As of June 30, 1997, 45 IMF member countries officially pegged to a single currency and 20 countries pegged to the SDR or another currency composite.
Most exits involved a devaluation and a new peg. rather than a move to flexible rates.
See Krugman (1979). At the same time, evidence for the particular mechanism assumed in these first-generation models 10 be responsible for the excessive money growth and inflation, namely, government budget deficits financed through money creation, is considerably less robust. There is only weak evidence that countries suffering attacks run unusually expansionary fiscal policies in the period leading up to the event. Again, see Eichen-green. Rose, and Wyplosz (1995).
Ozkan and Sutherland (1994). Compared with their first-generation predecessors, the advantage of these second-generation models is that they do not rely on the exhaustion of international reserves to explain the speculative attack, a mechanism that is less plausible in a world of high capital mobility where governments and central banks are able to borrow reserves abroad. See Buiter (1987).
These relationships have been invoked to motivate the idea that speculative attacks can be self-fulfilling—that their very occurrence can shift an economy from one equilibrium to another. The idea is not that speculative attacks can occur and currencies can collapse for any reason, rather, it is that self-fulfilling attacks are possible when a country enters a danger zone in which unemployment is too high, debt is too heavy, or the banking system is too weak for the authorities to credibly persist in the policies needed to defend the currency. See Obstfeld (1994).
Again, see Klein and Marion (1994), It is also the case, as noted above, that the costs of devaluation are highest when there has been a significant political commitment to the peg.
In addition, in their case and in Austria’s, the fact that the country’s economic structure is so similar to the country to which it pegs minimizes the incidence of asymmetric shocks. In terms of economic theory, these countries come close to comprising an “optimum currency area” with the country to which they peg. See Appendix t and Bayoumi and Eichengreen (1992).
Speculative attacks may have an element of self-fulfilling expectations. Vulnerability to self-fulfilling attacks seems to be especially great when the country is exposed to a large amount of short-terin, foreign currency debt. Short-term debt was an important factor for precipitating crises in Mexico and Thailand, consisting mainly of debt issued by the government in the former country, and by ihe private sector in ihe latter. Likewise, speculative attacks may on occasion occur because of contagion effects rather than the fundamentals of the country concerned—though vulnerability to contagion may be heightened by having some of the same characteristics as the crisis country.
If there are reasons to think that the exchange rate might weaken with the shift to a more discretionary monetary policy, then there may be a case for lightening monetary policy to avert this outcome. The alternative is to establish a clear alternative framework for policy to supersede the exchange rate anchor, as described below.
Implementing inflation targeting requires a degree of independence of the central bank and other prerequisites that may not be satisfied in some developing countries. For a discussion, see Masson, Savastano, and Sharrna (1997).
Thailand’s experience shows that use of indirect monetary instruments had been limited, and the need to maintain stable exchange rates under strong inflows of capital brought challenges to monetary policy in an environment with progressive financial and capital account liberalization. The central bank relied considerably on foreign exchange swaps to manage liquidity effects of capital inflows that involved setting a forward exchange rate that, in the context of a fixed exchange rate, did not deviate significantly from the spot rate. This strategy turned out to be quite costly for the authorities following the floating of the baht.
If the exchange rate is immediately under substantial upward pressure, it is difficult to allow only gradual appreciation as this will create expectations of further appreciation that will motivate strong capital inflows (absent a significant and probably undesirable reduction in domestic interest rates). Some step appreciation is generally necessary in such situations.
If a country should want to exit from a currency board arrangement, as Lithuania has recently announced it does, then an initial move to a currency peg merits serious consideration.
For a survey of early warning indicators of currency crises, see Kaminsky, Lizondo. and Reinhan (1997), While this research makes a useful contribution, it remains difficult to accurately predict the timing of speculative crises, as argued above, which makes prompt action when there are indications of vulnerability especially important.
In a historical study of some 20 industrial countries, Eichen-green. Rose, and Wyplosz (1995, see especially Table 2) find that the presence of capital controls is correlated wilh a lesser frequency of devaluation and an increased tendency for failure of speculative attacks. This result is consistent with the view that the presence of controls is associated with a lower degree of openness to capital flows, both inflows and outflows, and this lesser degree of openness (whatever its costs) provides some insulation against speculative attacks, Introducing new controls on capital outflows in a crisis, after substantial foreign capital has flowed into a country, is very different from maintaining controls that may help to contain outflows by also discouraging inflows.
For example, as the government generally needs to act as the protector against a general collapse of the financial system, there is clearly a public policy interest in ensuring that financial institutions do not undertake imprudent foreign exchange risks in their on-or off-balance sheet activities. More broadly, it may be argued that public policy should also be concerned about the risks of excessive short-term foreign currency borrowing by domestic enterprises that, among other things, may cause severe problems for the financial sector in the event of large exchange rate movements. Prudential regulations to deal with these concerns may appropriately focus more on the form of capital inflows, especially short-term foreign currency borrowing, rather than on the overall level of such inflows; and they may well be more effective in influencing the structure of inflows rather than the overall level. For more complete discussion of issues relating to capital controls, see International Monetary Fund (1995a).
See, in particular, Obslfeld and Rogoff (1995).
Kenen (1969) pointed out that what was also needed was mobility between industries, not between regions, since output in each region was unlikely to be homogeneous.
The sample of exits was constructed by checking the arrangements given in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions against exchange rate data to confirm that the exits led to an appreciable movement of the exchange rate.
It can be argued that exit strategies are not an issue for the majority of high-income countries, either because they are already committed UJ a floating exchange rale or because, as in Europe, they are moving toward permanent fixing and then elimination of the exchange rate through the process of monetary unification.
All data used to constitute the exit cases were nonoverlapping. Countries had to continue to peg for the entire sample period to be included in the control group of peggers that did not exit.
Since crawling pegs and crawling bands were already included in the “greater flexibility” category of exchange rate arrangements in the official IMF taxonomy, cases of movements from crawling pegs and crawling bands to managed floating and free floating were not included here in the list of exits. Thus, the definition of exits is relatively restrictive.
All the data are from databases at the IMF and the World Bank. Most of the data were taken from the Frankel and Rose’s (1996a) database—kindly provided by Gian Maria Milesi-Ferretti—which is based on the World Bank’s databases. We also added, completed, and updated some of the series with information from the World Bank’s World Development Indicators and Global Development Finance, and the IMF’s International Financial Statistics databases.
In fact, of the 29 cases of exits, 23 occurred in periods of crisis according to the Frankel-Rose criterion. This criterion defines a crisis as a period when there is a large fall in the exchange rate that is also significantly larger than any decline in the currency’s value in the preceding period. It was possible to replicate the analysis that follows not for the full sample of 29 exits but for the 23 exits in times of crisis only. The results were virtually indistinguishable from those reported in this appendix. Thus, the fact that our exits mix together crisis and noncrisis cases is inconsequential for the results.
The month of the exit in the case of real and nominal exchange rates, the year of exit in the case of other variables.
That the standard deviation of the real and nominal rates remains noticeably higher after the exit reflects the well-known volatility of floating rates. See, for example, Mussa (1986) and Rose (1994),
Again, relative to the control group.
It would be desirable to have information on the spread between deposit and loan rates, which tends to move in tandem with the level of nonperforming loans and thus to signal future banking problems, but data on this variable were not available for many of the countries in the sample.
A zero-one variable such as this raises the danger of giving the same weight to restrictions that have very different purposes and effects.
Cottarelli and Giannini (1997) provide some support for this view.
More surprisingly, Figure A4 suggests that countries that exit tend to reimpose current account restrictions (with a significantly higher probability than countries with lasting pegs). This could be another sign that a number of such countries exited under severe duress and responded to the trauma by rolling back earlier liberalization measures. Again, the fragility of the data suggests treating this finding with caution.
On the other hand, the fact that current account deficits are smaller in the exit cases (and capital inflows are likely to be correspondingly larger) than in countries with lasting pegs is perhaps more consistent with the interpretation that they are exiting voluntarily, it is likely that we have examples of both in the sample. Still, both interpretations are plausible, and which one applies in a particular case must be determined by detailed consideration of individual cases, as is presented in Appendix III.
For an account of Chile’s 1982 crisis and subsequent recovery, see Edwards and Cox Edwards (1991) and the references contained therein.
A fluctuation band of ±0.5 percent had been introduced in August 1984, but that margin was seen as a normal buy/sell spread in the interbank market,
The band was widened to ±3 percent in June 1988, ±5 percent in June 1989, ±10 percent in January 1992, and ±12.5 percent in February 1997,
This breakdown is proposed by Vergara (1994).
A remarkable achievement, considering that a real effective depreciation of 40 percent had already taken place between May 1982, the month prior to the devaluation, and June 1985. when the 2 percent band was adopted.
Inward capital transactions, which had generally been free of restrictions, were restricted through minimum holding periods and reserve requirements. In addition, the Chilean authorities delayed the removal of restrictions on capital outflows on the assumption that these would also deter inflows (see Williamson (1996)).
The exchange rate was devalued by 19 percent and then fixed at the rate of 1.5 new shekels per U.S. dollar. In August 1986. the peg to the U.S. dollar was replaced by a peg to a basket of currencies, whose composition has changed on a few occasions.
Helpman, Leidemian. and Bufman (1994), p. 273, note that the real exchange rale was stabilized at an overvalued level during this period.
Average annual inflation was reduced and stabilized at around 10–13 percent, but sometimes inflation exceeded the pre-announced target.
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