- Inci Ötker
- Published Date:
- April 2007
Many countries moved toward more flexible exchange rate regimes over the past decade.1 Among the factors underlying the move to greater flexibility has been the belief that more flexible exchange rates provide a greater degree of monetary policy autonomy and flexibility in responding to external shocks, including large and volatile capital flows. Flexible exchange rates have been expected to (1) reduce one-way bets against currencies, thereby discouraging short-term capital inflows that can be easily reversed; (2) discourage a buildup of large unhedged foreign currency positions by reducing the implicit exchange rate guarantees implied by pegged and tightly managed exchange rates; and hence (3) stimulate prudent risk management and foreign exchange (FX) market development as market participants seek to hedge against potentially greater exchange rate risks.
There is often a reluctance to let go of pegged exchange rates despite these benefits (the so-called fear of floating). Policymakers tend to keep the pegs, reflecting, in general, the perceived costs of exchange rate volatility related to (1) concerns about losing policy credibility; (2) adverse effects of a potential appreciation of the domestic currency on external balances; (3) higher inflation from exchange rate pass-through (given the limited technical and institutional capacity to implement alternative monetary policy frameworks such as inflation targeting (IT), and underdeveloped financial markets characterized by larger exchange rate fluctuations); and (4) potential losses from currency mismatches, in particular when markets and instruments to hedge against risks are limited. The difficulties in assessing the right time to exit and in determining the alternative regime to adopt tend to be additional factors in this reluctance.
Such concerns about floating hence affect the pace and manner in which countries move to greater flexibility. Some countries that put significant emphasis on preparedness for floating chose a cautious and gradual approach to greater flexibility while working on establishing the necessary supportive elements of floating rates. In other countries, authorities experienced difficulty in managing the exits that occurred under market pressure when flexible exchange rates were adopted with little preparation devoted to addressing the fears of floating. Country experiences suggest that those that work on mitigating risks associated with floating (Figure 1) can achieve a smoother exit from their pegged regimes, even when the elements supporting greater flexibility are not fully in place before the move to greater flexibility.
Figure 1.Addressing the “Fear of Floating” Box 1.Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates
This box provides a brief summary of the main points of the IMF’s operational framework for moving toward exchange rate flexibility.1 This framework provides hands-on guidance on the institutional, operational, and technical aspects of moving toward exchange rate flexibility, presenting in turn a context for the country experiences in Part 1: Section II and Part 2.
Although the timing and priority accorded to each of these areas may vary from country to country depending on initial conditions and economic structure, the successful ingredients for floating include (1) developing a deep and liquid FX market, (2) formulating intervention policies consistent with the new exchange rate regime, (3) establishing an alternative nominal anchor in the context of a new monetary policy framework and developing supportive markets, and (4) reviewing exchange rate exposures and building the capacity of market participants to manage exchange rate risks and of the supervisory authorities to regulate and monitor them.2
Operating a flexible exchange rate regime works well only when there is a sufficiently liquid and efficient FX market for price discovery. A well-functioning FX market allows the exchange rate to respond to market forces, helps minimize disruptive day-to-day fluctuations in the exchange rate, and facilitates exchange rate risk management. Developing (spot and forward) FX markets requires eliminating market-inhibiting regulations, improving the market microstructure (for example, by allowing risk-hedging instruments, simplifying FX legislation, or putting in place adequate payment and settlement systems), and increasing information flows in the market, while reducing the central bank’s market-maker role. Allowing some exchange rate flexibility is a key step in limiting what is, to some extent, an unavoidable chicken-and-egg problem: Exchange rate flexibility requires a deep market and better risk management, but a deep market and prudent risk management require flexibility. Providing for a two-way risk is also important, in fostering better management of risks and minimizing destabilizing trading strategies (and, thereby, the risk of disorderly exits).
Private sector FX risk exposure can have an important bearing on the pace of the exit, the type of flexible exchange rate regime adopted, and intervention policies, requiring a careful management of the transfer of FX risk back to the private sector and systems to monitor and manage the private sector’s exposures. In managing the FX risk, the market participants need to develop analytical and information systems to monitor and measure risks in addition to internal risk management and prudential procedures. Adequate prudential and supervisory arrangements and enforcement capacity also need to be in place so that bank’s direct and indirect FX exposures and related risks can be monitored. Although early investment in these elements is typically beneficial by itself, it can also help mitigate the risk of disorderly exits; having an effective FX-risk-related supervisory and prudential framework can limit contagion of financial crises. Careful development of derivatives markets for foreign exchange with appropriate safeguards is an essential element in building capacity to manage FX risks, while limiting their potential misuse for speculative activity.
Transition to flexible exchange rates creates the need to develop a coherent intervention strategy that has specific policies on objectives of intervention. Intervention strategy becomes discretionary under a flexible exchange rate regime, so it is essential to set up well-specified intervention principles to enhance the credibility of the new regime. Whether the objective is to correct misalignments, calm disorderly markets, meet reserve targets, or supply publicly acquired foreign exchange, care needs to be taken to signal commitment to a market-determined rate and avoid excessive smoothing of short-term fluctuations. Avoiding excessive smoothing is crucial so as not to suppress the nascent markets and useful market signals and to avoid sending confusing messages about policy intentions. Transparency of intervention policies is important in building confidence in the new regime, especially after forced exits. A public commitment to the objectives and principles of intervention enables market scrutiny and accountability for FX operations.
Moving to flexible exchange rates also creates the need to replace the exchange rate with another credible nominal anchor and to redesign the monetary policy framework around the new anchor. Having a credible alternative framework is essential in stabilizing market expectations and maintaining or regaining credibility and monetary stability in the aftermath of exiting a peg or a disorderly exit. Many countries moving to flexibility in recent years have favored IT frameworks over money-targeting ones, as the effectiveness of the latter has been limited by the weak relationship between monetary aggregates and inflation. A credible alternative such as IT, however, requires extensive preparation, with substantial amount of capacity building and credibility building, and thus planning ahead for the transition is critical to achieving an orderly exit. A lengthy transition period reflects, in part, the time required to fulfill the necessary institutional requirements and macroeconomic conditions (see Eichengreen and others, 1999; IMF, 2000a and 2000b; Mishkin, 2000; Carare and others, 2002; and Fraga, Goldfajn, and Minella, 2003).
Countries planning to move to a floating regime face important questions on the pace of the exit and its sequencing with other policies, including capital account liberalization. Often, these questions involve difficult trade-offs, and considerations (including the degree of preparedness, the openness of the capital account, the macroeconomic situation, and conditions in domestic and international markets) that are often country-specific. If taken from a position of macroeconomic strength, a faster exit is beneficial in signaling determination and enhancing the credibility of monetary policy, but the speed at which relevant institutions can be built is often a main determinant of the pace at which an orderly exit can proceed. In general, early preparation for float is essential in bolstering the chances of success of the exit—gradual or rapid, with the elements taking the longest time to build (for example, capacity to operate under an alternative framework and markets) put in place first.
Clear trade-offs are involved in the sequencing of exchange rate flexibility with capital account liberalization. There are risks to opening the capital account before adopting a flexible exchange rate; many countries were forced off pegs after sudden reversals of capital flows, whereas others faced heavy inflows and appreciation pressures on their pegs. On the other hand, liberalizing the capital account can help offset transitory current account shocks, expand the instruments for risk management, and deepen the FX market, all of which are important for operating a flexible exchange rate. The transition to flexibility can in general be facilitated by removing or strengthening existing asymmetries in the openness of the capital account to support an orderly correction of misalignments (for example, by liberalizing outflows to reduce pressures from inflows and/or liberalizing long-term inflows before short-term ones).
An earlier IMF study described the institutional, operational, and technical aspects of moving toward flexibility that are important for a successful transition (referred to henceforth as the fixed-to-float framework). The framework (provided in Duttagupta, Fernandez, and Karacadag, 2004, and subsequently endorsed by the IMF Executive Board in December 2004) concluded that for a successful transition to a floating regime, the following four “ingredients” were generally needed: (1) developing a deep and liquid FX market, (2) setting up adequate systems to review and manage exchange rate risks, (3) formulating coherent intervention policies consistent with the new regime, and (4) establishing an appropriate alternative nominal anchor in the context of the new monetary policy framework (IMF, 2004a and 2004b). This framework is summarized in Box 1.
This paper presents the concrete steps a selected number of countries took in transitioning to greater exchange rate flexibility, elaborating on the operational attributes that proved helpful in promoting successful transitions. It does so in the context of actual country studies, covering three countries with exits under market pressure (Brazil, Czech Republic, and Uruguay), and three countries with gradual and orderly transitions (Chile, Israel, and Poland). The particular issues addressed are how the various operational ingredients for floating identified in the fixed-to-float framework were established and coordinated with the exit, how their implementation interacted with macro and other conditions, and how these ingredients contributed to the smoothness of the exit.
The case studies cover only durable exits, to identify the factors that contributed to the durability of the transitions in the sense that the move to flexibility has not been subsequently reversed. To supplement this, Appendix II summarizes the experience of three countries with short-lived exits (Ecuador, Pakistan, and Uzbekistan), and Appendix III presents an example of an ongoing transition to a flexible regime (Ukraine). The examples in Appendix II highlight the factors undermining durable exits, and the example in Appendix III illustrates the many challenges faced in the transition process.
The paper is organized as follows: Section II in Part 1 provides a synthesis of the six country experiences in the context of the fixed-to-float framework and identifies the operational attributes that proved particularly helpful in promoting smooth and durable exits to floating regimes. Sections III and IV in part 2 present the detailed case studies for orderly and disorderly transitions, respectively.