In the discussions preceding the formation of the IMF, issues of convertibility and choice of exchange rate regime were closely interwoven (see Section III). A basic objective was to set up a system in which current account convertibility would be consistent with the aims of the fixed exchange rate regimes—convertibility at fixed though adjustable rates—and thus to create a favorable environment for international trade.

In the discussions preceding the formation of the IMF, issues of convertibility and choice of exchange rate regime were closely interwoven (see Section III). A basic objective was to set up a system in which current account convertibility would be consistent with the aims of the fixed exchange rate regimes—convertibility at fixed though adjustable rates—and thus to create a favorable environment for international trade.

With the advent of generalized floating and the Second Amendment of the IMF’s Articles, obligations of members regarding their exchange rate policies changed fundamentally from those embodied in the original Bretton Woods Articles, and, as amended, Article IV now gives members wide latitude in their choice of exchange arrangements. (The only practices proscribed are a peg in terms of gold and, under Article VIII, multiple exchange rates.) In return, members agree to comply with certain broad obligations relating to the underlying stability of exchange rates and other more narrowly focused obligations, and the IMF in turn is responsible for overseeing each member’s compliance with these obligations. The broadest obligation of each member is to collaborate with the IMF and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. To this end, Article IV enumerates four particular obligations of the member countries. Two refer to the member’s economic and financial policies: (1) to endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability: and (2) to seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic conditions. The other two obligations refer more specifically to exchange rates: (3) to avoid manipulating exchange rates or the international monetary system to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members; and (4) to follow exchange policies compatible with members’ undertakings under Article IV.

Members must provide sufficient information to enable the IMF to exercise firm surveillance. Each member is obliged to notify the IMF of its exchange arrangements within 30 days of becoming a member, and promptly thereafter of any subsequent changes.

Exchange rate policies, and the regimes that express them, are a central focus of the IMF’s work, and the various aspects of the policies have therefore been reviewed in a number of studies prepared by the staff.34 The purpose of the discussion here is to bring to bear some empirical observations that derive from the IMF’s annual and quarterly reports on main developments in regimes.35

Trends in the Use of Exchange Rate Regimes

From the time the IMF was established until generalized floating in 1973, the international monetary system was based on the original Bretton Woods system of par values, with a few exceptions of long-standing floating regimes that included an industrial country (Canada) and a developing country (Lebanon).

Exchange Rate Classifications

Since 1973, exchange rate regimes adopted by members have covered a broad spectrum, ranging by degree of flexibility from single currency pegs to free floats. Most countries have adopted regimes that fall fairly readily into one or another of the major categories of the classification system adopted by the IMF in 1982 (see Box). Countries with dual or multiple exchange markets normally have one market that is clearly the most important, and the IMF’s classification refers to that market.

Within the group of fixed-rate arrangements, several deserve separate discussion. In the most pure form of a single currency peg, the currency of another country circulates as legal tender, for example, the Australian dollar in Kiribati, the Italian lira in San Marino, the Russian ruble in Tajikistan, and the U.S. dollar in Liberia, the Marshall Islands, the Federated States of Micronesia, and Panama. In these countries, the financial stability provided by unifying the currency with the currency of the larger country, and thereby reducing administrative costs, was judged to be more important than the loss of seigniorage and absence of an independent monetary policy. A closely related type of peg is a currency board arrangement, whereby the country in question pegs its currency to the currency of a larger country, and the issue of domestic currency is fully backed by the foreign currency. Argentina, Estonia, Hong Kong, Lithuania, and Singapore use modified versions of currency boards.36

Exchange Rate Classifications

Peg: Single Currency. The country pegs to a major currency—usually the U.S. dollar or the French franc—with infrequent adjustment of the parity.

Peg: Currency Composite. A weighted composite is formed from the currencies of major trading or financial partners. Currency weights are generally country-specific and reflect the geographical distribution of trade, services, or capital flows. They can also be standardized, such as those of the SDR and the ECU.

Flexibility Limited vis-à-vis Single Currency. The value of the currency is maintained within certain margins of fluctuation around the de facto peg, corresponding empirically to volatility within the regime of wider margins that preceded the Second Amendment.

Flexibility Limited: Cooperative Arrangements. This regime refers to countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS) and is a conceptual cross between a peg of each EMS currency to others in the system (currently within wide margins), and a float of all EMS currencies jointly vis-à-vis non-EMS currencies.

More Flexible: Adjusted According to a Set of Indicators. The currency is adjusted more or less automatically in response to changes in selected quantitative indicators. A common indicator is the real effective exchange rate that reflects inflation-adjusted changes in the currency vis-à-vis major trading partners: another is a fixed, preannounced change.

More Flexible: Managed Float. The central bank quotes and supports the rate but varies it frequently. Indicators for adjusting the rate are broadly judgmental, including, for example, the balance of payments position, international reserves, or parallel market developments, and adjustments are thus not automatic.

More Flexible: Independent Float. Rates are market-determined, with any intervention aimed at the moderating rate of change, rather than at establishing a level for the rate.

A currency union is an arrangement under which a common currency circulates at par among the members. The seven countries that make up the West African Monetary Union maintain a common currency, the CFA franc, which is issued by the BCEAO and is fixed in terms of the French franc. The CFA franc is also issued at the same fixed exchange rate by the BEAC to the six member countries of the Central African Monetary Area,37 in which the CFA franc is also the common currency.38 Similarly, eight Caribbean countries39 maintain fixed exchange arrangements and use a common currency, the Eastern Caribbean dollar, which is issued by the Eastern Caribbean Central Bank and is pegged to the U.S. dollar. These arrangements differ from those of the cooperative arrangements in EMS countries, which do not use a common currency and must therefore actively coordinate their economic policies.

At the other end of the spectrum, the distribution between managed and independently floating arrangements is important because it often reflects the policy stance for full, or limited, market determination of the exchange rate. In countries with managed regimes, as with pegged and other less flexible regimes, the foreign exchange market does not necessarily clear—even in the limited sense of equalizing supply and demand in the presence of restrictions on foreign exchange flows—and the result has often been the emergence of a parallel, or black market, exchange rate. In contrast, under independently floating regimes, supply and demand is in continuous equality, albeit in the very short run partly as a result of intervention or exchange controls. Moreover, intervention is limited in the independently floating group because, by definition, the authorities may intervene only to smooth the exchange rate and not to establish a particular level for it.

The number of member countries that peg their currencies to a single currency or a basket of currencies, as well as these countries’ share in world trade, has decreased in recent years. The decline is even more marked if one excludes individual country peggers that adhere to some form of regional arrangement and thus have less true discretion regarding their choice of regime. At the other extreme, the number of countries with more flexible exchange rates (particularly independently floating) regimes has increased (Chart 3).

Chart 3.
Chart 3.

Trends in Selected Exchange Regimes

(Number of countries)

Source: IMF, AREAER (various issues).1Including countries having limited flexibility against the U.S. dollar.2For 1992, this category include six countries whose currencies were pegged to the Russian ruble and six to other currencies.

Changes in Arrangements

During 1991–94, individual changes in exchange rate regimes continued to be almost universally oneway shifts toward more flexible arrangements.40 Thirty-nine members reclassified their exchange regimes from pegs to more flexible arrangements, while only six members moved from a more flexible arrangement to a peg. The 39 reclassifications to more flexibility occurred in a variety of ways, with the industrial country reclassifications (Finland, Italy. Norway, Sweden, and United Kingdom) being largely the result of the ERM crisis in 1992.41 and the developing country reclassifications generally implemented as a part of overall policy packages: 14 countries42 adopted floating arrangements upon unification of multiple or dual exchange arrangements; 9 countries43 introduced interbank foreign exchange markets or auctions or shifted most transactions to the free foreign exchange market; 5 new members44 introduced independently floating national currencies: and 6 countries adopted floating rates through other measures.45

Concerning the six members whose regime was reclassified from a more flexible arrangement to a peg, Nepal pegged to a basket of currencies and Argentina’s administration introduced a fixed-rate regime in the context of a comprehensive economic program. Nicaragua also moved to a peg during the period but subsequently moved back to a managed float. Nigeria and Venezuela moved to the U.S. dollar peg with the aim of containing a depreciation of the national currency, together with tighter exchange controls. Lithuania introduced a currency board arrangement in the context of a U.S. dollar peg, whereas Turkmenistan introduced a U.S. dollar peg for the official exchange rate.

A number of countries adopted more managed exchange rate arrangements that offered discretion to the authorities in setting the exchange rate without necessarily adopting a peg: the Malaysian ringgit and the Colombian peso were classified as managed floats: Israel, Nicaragua, Poland, and Sao Tome and Principe adopted a preannounced crawling peg system; Argentina and, for an interim period, Nicaragua pegged to the U.S. dollar; and Portugal joined the ERM. Four countries, including one of the above, switched from one form of currency peg to another.46

Between 1991 and 1994, IMF membership increased significantly as the countries of the former Soviet Union and the Baltic countries joined the institution. A number of these countries were using the Russian ruble at the lime of accession to membership in the IMF hut, as of the end of September 1994, 10 out of 14 countries in this group that had reported their exchange arrangements to the IMF were classified as having more flexible exchange rate regimes for their own currencies or coupons, Uzbekistan has not notified the IMF of its exchange arrangements. Tajikistan remains pegged to the Russian ruble, while Estonia has adopted a peg to the deutsche mark, and Lithuania and Turkmenistan to the U.S. dollar. Eritrea became a member of the IMF in July 1994 but has not yet notified the IMF of its exchange arrangement (the Ethiopian birr is used as a provisional currency). The Slovak Republic pegs its new currency to a basket consisting of the U.S. dollar and the deutsche mark.

Forward Exchange Rate Regimes

Forward foreign exchange markets play an increasingly important role in market-based exchange systems in both industrial and developing countries. Forward exchange markets have developed very rapidly since the early 1980s and were last reviewed by the IMF in 1988.47 Forward regimes include restrictions on forward cover transactions and, in some developing countries, arrangements for central bank determination of the forward premiums or discounts, or provision of exchange rate guarantees by the central bank. Major forms of such restrictions on access are underlying (“real”) transaction requirements, limits on maturities, and approval requirements for specific types of transactions. Access restrictions affect the extent of available coverage of transactions. Among the three major categories of transactions in forward exchange markets, namely, commercial transactions and scheduled debt-service payments, interest arbitrage transactions, and transactions without underlying transactions, a number of developing countries permit forward cover only for the first category. Forward cover for transactions in the second category is allowed in countries that have capital convertibility, so that international fund transfers to maximize yields on financial investments are permitted, although often only banks are permitted to undertake such interest arbitrage transactions. The third category covers purely speculative transactions that accompany open foreign exchange positions. In an attempt to limit speculative transactions, many developing countries prohibit these underlying transactions.

Since 1986, when the practices were last surveyed, most industrial countries have eliminated restrictions on access to the forward markets and underlying transaction requirements and have removed limits on maturities available in forward markets (Table 2). A number of countries also abolished prior approval requirements by type of transaction. As a result, all industrial countries other than Iceland now have market-determined forward exchange rate systems. In addition, a number of countries have removed restrictions on forward cover activities, such as access restrictions, underlying transaction requirements, limits on maturity, and approval requirements for specific types of transactions (Austria. Denmark, Finland, France. Ireland, Italy. Norway, Spain, and Sweden have recently eliminated restrictions.) As a result, of the industrial countries with a forward exchange market, only Greece now has limits on access to its forward cover markets or on maturity, and none of them has underlying transaction requirements.

Table 2.

Industrial Countries: Main Features of Regulations Affecting Forward Exchange Markets, December 31, 1993

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Sources: IMF, AREAER (various issues); and national authorities.Note: “Yes” indicates it is a practice under the exchange system; “No” indicates it is not;—indicates that information is not available; and—indicates that the information is not applicable.

Developing Countries

Since the IMF last surveyed forward market practices in developing countries in 1988, there has been continued liberalization and development of these markets (Table 3), Five larger developing countries have been added to those in which cover can be obtained from commercial banks (Brazil, Hungary, Israel. Mexico (up to six months), and Turkey), After 1988, Argentina adopted a fixed exchange rate and previous commercial cover arrangements ceased to be available.

Table 3.

Summary Features of Forward Exchange Systems in Selected Developing Countries, December 31, 1992

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Sources: IMF, AREAER (various issues); and national authorities.

Parallel (not officially recognized) market.

Provided only to public sector agencies engaged in trade in special circumstances (not being utilized in Egypt).

Market was inoperative in early 1988.

Central Bank provides forward cover to banks only for corporations or projects of vital national interest.

Authorized financial institutions provide short-term (up to six months) forward cover for foreign exchange operations.

As a counterpart to the increased role for forward markets in the private sector, a number of countries either stopped regulating forward exchange rates for cover provided by the private sector (Hungary, Israel, and Turkey) or stopped providing cover directly through official agencies (Argentina, Costa Rica, Israel, Philippines, and Venezuela). In two countries (Kenya and Zimbabwe), official cover was introduced as an adjunct to private cover arrangements; it is now being phased out in Kenya.

The 1988 review of forward exchange markets underlined the dangers in officially run exchange rate guarantee schemes, which had resulted in large fiscal and quasi-fiscal losses in a number of countries. It also noted disadvantages of foreign exchange deposit accounts provided by commercial banks as hedging facilities because, unlike forward exchange contracts, they tie up liquidity. They may also raise questions of the banks’ being exposed to excessive exchange rate risk, particularly with unrealistic, nonmarket exchange rates.

On balance, the experience suggests that the optimal course is to wait for a market to develop in the private sector before providing cover rather than to try nonmarket approaches in the interim. The fact that such forward markets appear to be very sensitive to the overall level of financial sector liberalization and development is another important reason to accelerate broad reforms.

Multiple Exchange Rates

Multiple exchange rates, defined as different effective exchange rates for a currency applied to different types of transactions, transactors, and currencies, result from market segmentation caused by official action and are subject to IMF jurisdiction. Multiple exchange rates have been used for various purposes, including balance of payments objectives and to discourage or promote specific transactions, increase revenue, control prices, or subsidize specific parties.48 Whatever the purpose, multiple exchange rates influence and distort relative prices, the distribution of income, and the allocation of resources. Multiple exchange rates are distorting not only from the standpoint of economic efficiency but also from the standpoint of fairness, such as when authorities use them to provide special treatment for specific groups. Even when multiple exchange rates are implemented to correct a domestic market imperfection, such official action tends to create new and possibly more serious distortions elsewhere in the economy.

Developments in the Use of Multiple Exchange Rates

The number of countries using multiple exchange rates either to liberalize or to tighten foreign exchange restrictions can provide an overall sense of the extent to which countries are using the exchange system as a tool to manage their external accounts. These numbers may, however, be misleading if they include countries implementing transitional measures before liberalizing transactions in sequence.49 Thus, the introduction of multiple currency practices does not necessarily mean that the degree of complexity or restrictiveness of an exchange rate system has increased. Moreover, there are various types of multiple currency practices, and their scope and incidence can vary widely and be difficult to measure.

The number of countries with multiple exchange rates in 1991–93 averaged 32, compared with 42 in 1989–90, and the share in trade of member countries with multiple exchange rates has fallen. In 1993, countries with multiple exchange rate systems represented only about 3.6 percent of total trade, compared with 13 percent in 1986 and 1988, and 8 percent in 1990. Brazil. China, and Mexico, which previously represented about 4 percent of total trade, have unified their exchange rates.

The trend away from multiple exchange rates has been evident since the 1950s, although progress has not been continuous. In the early 1950s, the world dollar shortage, and the problems of bilateralism and inconvertibility stemming from it, accompanied an increased use of multiple currency practices by industrial and developing member countries. Some two-thirds of the membership engaged in such practices in 1955; weighted by trade, the incidence was about one-third of the membership. In June 1957, the IMF urged members to simplify their exchange rate structures: it also undertook to assist members in their efforts to do so, providing technical assistance where appropriate.50 In the late 1950s and early 1960s, these efforts, together with the establishment of convertibility among industrial countries and an improvement in the international trade situation, helped to simplify the exchange rate systems in both industrial and developing member countries. Progress in simplifying developing countries’ systems was mixed thereafter, and the use of multiple exchange rates increased in the late 1960s (particularly in the form of advance import deposit requirements accompanied by import surcharges resulting from the increasing misalignment of exchange rates) and again in the early 1980s (in response to widespread balance of payments difficulties).

The number of countries operating some form of multiple exchange rate regime declined from 46 in 1986 to 44 in 1988 and to 32 as of the end of September 1994, or about 20 percent of the IMF’s membership. Multiple currency practices are applied to capital transactions in ten countries. However, only in some of the members of the South African Common Monetary Area were multiple exchange rates applied broadly to capital transactions rather than to certain specific capital operations.

Recent developments in countries with multiple currency practices represent a continuous trend of liberalization and movement toward unified exchange rate regimes. However, a number of IMF members introduced new multiple currency practices during 1991–94, raising the question of whether they are reverting to restrictive regimes. The answer to this question appears to be no. Most of these countries introduced a multiple exchange regime as a transitional measure that was part of a plan to liberalize the exchange and trade regimes; the majority of them were therefore approved by the IMF. Also, many of the countries that became IMF members during this period had multiple exchange rates or introduced them in conjunction with a new national currency.

IMF Policy

Under Article VIII, Section 3, IMF members are obligated to avoid multiple currency practices. Multiple currency practices take many different forms but can be divided into five main categories: a dual or multiple exchange market system applied to broad categories of transactions; a separate, fixed exchange rate for specified transactions; taxes (or subsidies) that accrue to (or are paid by) the monetary or fiscal authorities on the value of specified exchange transactions or on exchange transfers; an excessive spread between buying and selling rates for foreign exchange; and broken cross exchange rates.

The Executive Board reviewed the IMF’s experience with, and policies for, multiple exchange practices in April 1984 and February 1985, concluding that multiple currency practices are costly in terms of efficiency and resource allocation and are not conducive to medium-term balance of payments adjustment.51 Most countries that introduced multiple currency practices did so at a time of external payments difficulties. In some cases, they did so to avoid a uniform change in the exchange rate—normally a devaluation—because they thought that it would entail high political and social costs. Some were concerned that a uniform devaluation would undermine growth prospects and cause inflation; others, that it would subvert social priorities by raising the costs of essential imports. Still others believed that development prospects would be endangered by the higher costs of importing inputs for priority sectors.

In some instances, a dual exchange rate was used as a temporary device to approximate a realistic level for a proposed unified exchange rate. Several countries established dual markets when their authorities were willing to unify the fixed official exchange rate with various other rates but were uncertain about the appropriate level for the new exchange rate. The movement of the exchange rate in the free secondary market provided information for the new official exchange rate, although in some countries a greater depreciation than warranted by economic fundamentals occurred in the secondary market. In other countries, the authorities intended to move from a fixed exchange rate system to a more flexible exchange rate system and to unify the official exchange rate with various other rates, official and unofficial, but were concerned about the lack of maturity of the interbank market or possible volatility of the exchange rate in the free market. These countries therefore maintained dual markets until these concerns were resolved.

Introduction of a multiple currency practice is subject to approval under Article VIII, and the IMF’s approval policies regarding multiple currency practices have remained flexible and responsive to each country’s circumstances. The IMF takes into account whether the multiple currency practices are intended to be temporary, at least when introduced.52 Approval of the practices is contingent upon the existence of a clear plan designed to bring about unification over a specific and appropriately brief period of time. A member undertaking an adjustment program supported by the use of IMF resources is normally expected to develop such a plan, which consists of either successive reductions in the dispersion of exchange rates through devaluation of the more appreciated rate(s) or shifts toward the free market of the transactions undertaken in the various exchange markets.