Abstract

This section examines how to achieve monetary policy credibility and price stability after a financial crisis.1 The experience of recent cases suggests that monetary policy by itself cannot restore stability following a crisis, but must be complemented by measures to close financing gaps and to solve banking sector problems without resorting to massive liquidity support. With respect to the choice of post-crisis exchange rate regime, stabilization can be achieved quite quickly under a floating exchange rate regime once the prerequisites have been met, and particularly when monetary policy is tightened early and sustained. In such cases, countries have typically moved progressively toward some form of inflation targeting, while attempts to use monetary aggregate budgeting have been less successful. Hard pegs have also had some success in reestablishing stability even in situations where the economy is in deep disarray, but disinflation has tended to be less complete, and countries often face a difficult exit problem.

This section examines how to achieve monetary policy credibility and price stability after a financial crisis.1 The experience of recent cases suggests that monetary policy by itself cannot restore stability following a crisis, but must be complemented by measures to close financing gaps and to solve banking sector problems without resorting to massive liquidity support. With respect to the choice of post-crisis exchange rate regime, stabilization can be achieved quite quickly under a floating exchange rate regime once the prerequisites have been met, and particularly when monetary policy is tightened early and sustained. In such cases, countries have typically moved progressively toward some form of inflation targeting, while attempts to use monetary aggregate budgeting have been less successful. Hard pegs have also had some success in reestablishing stability even in situations where the economy is in deep disarray, but disinflation has tended to be less complete, and countries often face a difficult exit problem.

The question addressed in this section is how to achieve monetary policy credibility and price stability after a financial crisis. We consider currency crises in which monetary policy credibility has been lost, focusing on the most severe episodes associated with broader banking and financial crises. This section draws on the evidence from ten recent crises: Brazil (1999); Bulgaria (1997); Ecuador (2000); Indonesia (1997); Korea (1997); Malaysia (1997); Mexico (1994), Russia (1998); Thailand (1997); and Turkey (2001).2

Prerequisites for a Credible Nominal Anchor

The countries that experienced currency crises generally went through two phases: an initial chaotic period of crisis containment, and a longer period during which the policy framework and institutions were more fully developed. The beginning of the crisis is defined as the month before the first large movement of the exchange rate (Table 4.1).3

Table 4.1.

Crisis Countries: Indicators of Recovery and Stabilization

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Source: IMF staff estimates.

Fall in output from quarterly peak in the year preceding (or following) the crisis to the lowest quarterly output level following the crisis.

Here and elsewhere in this table, inflation is measured as a three-month geometric moving average of the annualized monthly change in the CPI.

The latest observation is t + 17, since the crisis was relatively recent.

Inflation never fell below either 10 or 5 percent. Figures shown indicate inflation at t + 24.

On a nominal basis, the depreciation never stopped in Russia.

Volatility is measured as the standard deviation of daily changes in the log nominal exchange rate. Normal volatility is defined as the range observed in a number of developed and noncrisis emerging market countries with floating exchange rate regimes.

Volatility never returned to normal.

With major increase in volatility again in October/November 1995.

The first phase ended roughly when the free fall of the nominal exchange rate was arrested and exchange rate volatility declined markedly—which generally took a few months. The second phase has no well-defined end; this section focuses on the policies pursued and results achieved during the first two years after the beginning of a crisis.

The achievement of initial stability typically required meeting two conditions—in addition to a sound monetary policy.

  • Eliminating an ex ante dollar shortage. Sometimes, a credible monetary policy can only be achieved if it is supported by the provision of external finance or action on the debt. In particular, where shortage of foreign exchange was the key trigger for the currency and banking crisis, the excess demand for foreign exchange typically has to be eliminated—through default/rescheduling (Russia), provision of external support (Mexico), or a combination of external support and rescheduling/rollover of debt (Korea)—in order to reach nominal stability. Monetary policy alone (through the usual high-interest-rates, higher-capital-inflows channel) has generally been incapable of eliminating the ex ante gap in the midst of a crisis. At the height of the crisis, a tension exists between setting domestic currency interest rates high enough to compensate for risks of further depreciation and default and keeping them low enough to avoid raising the probability of default to unacceptable levels, given their effects on balance sheets and real activity. A similar logic applies to interest rates on dollar obligations: higher interest rates will not attract investors in the context of a panicky “rush for the exits.”4 Finally, the normal mechanisms to eliminate foreign exchange shortages, demand compression, and currency depreciation act over time but also do not serve this purpose effectively in the first few months of a crisis. Nor, arguably, should they: in a capital account crisis, the challenge is often to prevent an excessive contraction in domestic demand or a massive overshooting of the exchange rate. Thus, a strong monetary policy is usually an essential complement to external support, but it cannot substitute for it completely.

  • Solving related problems in the banking sector without resorting to massive liquidity support. The currency crises we studied were generally accompanied, and sometimes caused, by banking crises. Central banks in this situation often faced the dilemma of trying to manage monetary policy while also dealing with liquidity problems in the banking sector. Typically, this problem has been resolved by the government explicitly accepting responsibility for recapitalizing the banking system (see Section VI). As a result, rescuing the banking sector has led to large increases in (measured) public debt levels during these crises, often by 15 percent of GDP or more. Perhaps surprisingly, even countries that already had high levels of public debt were able to absorb this increase without compromising the achievement of initial stability. In some cases, however, the high debt load resulting from the banking crisis has reemerged as a problem a few years later and limited countries’ ability to conduct monetary policy (Brazil, Turkey) because of concerns about the effects of high interest rates on fiscal sustainability. In cases in which the sovereign defaulted on its obligations during the crisis (Russia, Ecuador), the government had to rely on mechanisms other than government-led recapitalization to resolve the banking crisis. In these cases, the government essentially had to eliminate its fiscal deficit in order to achieve nominal stability, since it could no longer borrow from the commercial banks, the public, or the central bank (i.e., print money). Figure 4.1 illustrates the complementary role of strong policy packages and adequate U.S. dollar financing in two important cases. Even after strong policies were put in place, in early December 1997, the Korean won continued to fall. Only the combination of an adequate financing package, through the coordinated rollover at the end of that month of external interbank debt, plus a further increase in interest rates, was sufficient to stabilize the exchange rate. Similarly, in Mexico in the beginning of 1995 quite high interest rates and substantial IMF financial support did not arrest the exchange rate collapse. The exchange rate stabilized only in mid-March, when interest rates were increased and the first disbursement of bilateral support eased doubts about the financing package.

Figure 4.1.
Figure 4.1.

Putting Together the Package

Experience with Post-Crisis Exchange Rate Regimes

Currency crises are characterized either by the forced abandonment of a fixed exchange rate regime or by a sharp depreciation in a floating one, often accompanied by a substantial loss of reserves. Given the loss of credibility, countries with a relatively open capital account have only two choices for the exchange rate regime in the immediate aftermath of a crisis: some variant of a float, or a very hard peg. Attempts to retain a soft peg after a controlled devaluation in the face of a major speculative attack are nonetheless surprisingly common and have generally ended in failure (Mexico, Russia, Brazil). It is hard to assess the cost of this additional loss of credibility in the first few days of the crisis, but it cannot help.5

Most countries studied succeeded in achieving nominal stability with a floating exchange rate regime. Although large depreciations and high exchange rate volatility have characterized the immediate post-crisis period, nominal stability has generally been restored quickly after the float was adopted, particularly in countries where inflation was low before the crisis. In most cases that floated, the nominal and real exchange rates ceased to depreciate within a few months, and exchange rate volatility also fell sharply (see Table 4.1). Where initial inflation was low, the period of “freely falling” exchange rates was fairly short, ranging from two months in Brazil to seven in Thailand and Indonesia.6 A fraction of the initial depreciation (i.e., the overshooting) was also reversed rapidly, generally within a year of the crisis; typically, the reversal occurred through nominal appreciation rather than through higher inflation. The depreciation did not unleash inflationary explosions. Most countries that floated achieved single-digit inflation (measured as annualized monthly price changes) within four to eight months, and lowered inflation further to 5 percent within two years. Furthermore, in most cases average inflation was below its pre-crisis level two years after the crisis. (Table 4.1 and Figure 4.2).7

Figure 4.2.
Figure 4.2.

Floaters and Fixers1

Source: IMF staff calculations.1 The floating-regime countries are Brazil, Korea, Malaysia, and Thailand. The fixed-regime countries are Bulgaria and Ecuador.2 Average inflation was negative between t+16 and t+20, so it does not display on the logarithmic right scale.

The success of the 1990s crisis countries in reducing inflation contrasts favorably with the difficulty that countries hit by the debt crisis of the 1980s had in reducing inflation. However, the depth of the problem also differed. Whereas in the 1980s inflation was a chronic problem typically rooted in large fiscal imbalances, in most of the 1990s crisis countries inflation (and monetization of fiscal deficits) was not a problem before the crises.

The countries that opted for a float in the aftermath of their 1990s crisis modified their exchange rate regime over time, after some measure of stability had been restored. In some cases, the float became a de facto crawling peg (Russia) or an explicit peg (Malaysia). In many other cases, the exit was eventually to inflation targeting (Mexico, Brazil, Thailand, Korea). This choice is discussed further below, under “The Framework for Monetary Policy in a Floating Regime.”

Two countries in this sample stabilized with hard pegs in the aftermath of a crisis (Bulgaria, Ecuador). Both did so after suffering extreme collapses in the exchange rate and especially sharp and prolonged increases in inflation. Thus, prior to the peg these two countries were pursuing an unsuccessful floating exchange rate policy in the absence of adequately tight monetary policy or other preconditions for nominal stability (or both). In particular, they had intractable banking and fiscal problems that severely limited the effectiveness of monetary policy. The timing of the adoption of the hard peg varied in the two cases. In Bulgaria, the currency board was formally adopted after the situation had stabilized, although its anticipated introduction served to anchor expectations. This delay, which was due to the electoral cycle, allowed the institutions to be established and permitted inflation to greatly reduce the real value of bank deposits and hence the fiscal cost of the banking crisis (although at a cost of the steepest recession in the sample). Ecuador’s dollarization permitted stabilization with almost no prior preparation, although here too the high inflation prior to the adoption of dollarization eroded the value of bank deposits (and was associated with a steep recession as well).

Interest rates (nominal and real) fell rapidly after the hard pegs were adopted, although inflation remained at higher levels than in countries that floated (Table 4.1; Figure 4.2 also shows average levels of inflation, interest rates, and the exchange rate for the two hard peg cases). The incomplete disinflation was probably a consequence of the initial overshooting of the exchange rate. The fixing of the exchange rate at an overly depreciated level created pressures for a real appreciation, which could only be accommodated via higher inflation.8

Notwithstanding the faster decline in real interest rates, and the more rapid adoption of a firm nominal anchor for monetary policy, the output decline (and ensuing recovery) was similar in the hard pegs and the floats. This presumably reflects the various initial conditions and shocks that shaped both choices and outcomes, as well as the policy choices themselves. There is no evidence, however, that the higher real interest rates that the floating countries experienced for a period of time had an obvious and large output cost.

Hard pegs had both benefits and costs for the countries that adopted them. Adoption of the hard peg anchored expectations and therefore provided a context more conducive to the adoption of fiscal and banking reforms, although it did not in and of itself resolve the banking and fiscal problems. Hard pegs constrain future exchange rate choices, however, in that exit is costly. The long-run costs (and benefits) of this constraint depend on the usual considerations that have been widely analyzed in recent years. From the perspective of a post-crisis country, whether the benefits of establishing credibility early on through a hard peg are worth the potential long-run costs will depend on the appropriateness of a hard peg over the long run for the particular country and on how difficult it would otherwise be to restore credibility. With respect to the question of which sort of hard peg to choose, dollarization is a more natural choice than a currency board for those countries that are more confident of the long-term value of the hard peg, as well as for those in too much disarray to implement a currency board.

The Stance of Monetary Policy in a Post-Crisis Float

The countries that floated and were most successful at quickly ending the period of volatility were those that tightened monetary policy early and sharply and that did not ease monetary policy until stability had clearly been restored. This monetary policy response resulted in a period of very high real interbank interest rates and, later, exchange rate appreciation. However, the success most countries achieved in lowering inflation did not require prolonged periods of higher real interest rates. Typically after an initial spike, nominal interest rates returned to pre-crisis levels or below in only a few months.9

A key objective of monetary policy in the aftermath of a float was to contain the exchange rate depreciation. The main rationale was to limit the overshooting and, hence, the inflationary impact of the depreciation. On the whole, the cases reviewed provide support for this rationale, in that monetary policy did help to reverse overshooting and hence limit the subsequent inflation.10 Korea, for example, raised interest rates sharply only two months after floating and rapidly undid much of the exchange rate overshooting. Partly as a result, post-crisis inflation was low (Figure 4.3). It took Mexico somewhat longer to arrest the overshooting. This, combined with ongoing doubts about the resolution of the dollar liquidity problem and other elements of the policy framework, resulted in a much longer period of overshooting and thus higher inflation pass-through. Indonesia took much longer to isolate monetary policy from the banking system problem and tighten consistently and had a much more protracted period of instability (see Figure 4.3). Eventually, both countries tightened monetary policy as much or more than the others in order to stabilize, to judge by the level of nominal and ex post real interest rates.

Figure 4.3.
Figure 4.3.

Short-Term Dynamics of Monetary Policy

(In percent)

Source: IMF staff calculations.

The decision on how tight to set monetary policy and for how long—that is, how much to resist initial overshooting and ensuing inflationary pressures— depends on several factors. Exchange rate and price adjustments can play positive roles in adjusting to the banking crisis and associated disequilibria. Some degree of exchange rate adjustment was clearly necessary where overvaluation or excess absorption (or both) were part of the problem (Brazil, Mexico, Thailand). In some cases it was also useful in reducing the real value of government and bank liabilities. Where deposits were not highly dollarized, the depreciation helped in some cases to reduce the real value of nonindexed banking system deposits (Indonesia; also Bulgaria and Ecuador prior to the peg). In others, it reduced the real value of government fixed-rate domestic liabilities (Russia).

Nonetheless, the degree of initial exchange rate depreciation observed in these cases was generally more than could be justified by the above considerations. It was important to avoid overshooting and keep ongoing inflation as low as possible. Particularly for countries with a history of poor monetary credibility (Mexico, Brazil) and where political and structural disarray is the most extreme (Indonesia), the risk is that high inflation becomes embedded in expectations and therefore makes subsequent disinflation highly costly. Another risk is that inflationary pressures become uncontrollable and lead to a hyperinflation. For countries with substantial U.S. dollar liabilities (Brazil, Indonesia, Thailand), excessive exchange rate depreciation is dangerous in its effects on balance sheets and, when the government is the U.S. dollar borrower, on fiscal solvency.11

The relationship between the stringency of monetary policy and the size or duration of output loss is weak. The fall in quarterly output exceeded 10 percent in most of the crisis countries; in general, the greater the fall in output, the longer it took countries to recover. Nevertheless, all but one of the countries had recovered at least half of the output loss within a year of the crisis (see Table 4.1). The floating countries that most quickly regained monetary policy control tended to have the smallest output declines. The causality is unclear, however: the rapidity with which countries regained monetary control and the limited fall in output may both have reflected a less devastating initial crisis. The case of Indonesia discussed above and shown in Figure 4.3 suggests that tighter policy eventually was necessary to restore stability. In this case, a looser initial policy may serve only to prolong the period of instability. There is certainly no strong evidence that tighter monetary policy was associated with larger output declines.

The Framework for Monetary Policy in a Floating Regime

Restoring credibility in the aftermath of a financial crisis requires setting up a monetary policy framework that helps to anchor public expectations. (Appendix 4.1 reports on the monetary policy framework post-crisis for each of the countries in the sample.) A hard peg achieves this almost instantaneously, since it provides a highly visible rules-based policy with no scope for discretion. With a float, the task is more demanding. The authorities need to choose the goals, intermediate and operating targets for monetary policy, and a battery of instruments to deploy in order to obtain these targets.12 In the initial phase, the goal in the majority of cases was to halt the free fall of the nominal exchange rate, limit inflation pass-through to reasonable levels, and restore some minimal stability. The policy environment inevitably involved a substantial ad hoc component during this phase as the overall policy package was being assembled. However, even then, the question of how to organize thinking about and communicate monetary policy posed itself immediately. Subsequent to the initial basic stabilization phase, the goal was to achieve price stability while balancing competing goals such as output stability.

The major issue that confronted the authorities was how to pursue monetary policy without relying on a single clear and operational nominal anchor. Countries can in principle choose to target a money aggregate or inflation. However, countries in this sample rarely followed a money anchor in the aftermath of a crisis. In a context where inflation is impossible to predict with any confidence, money targeting would seem to offer the promise of setting a money target as a clear nominal anchor—its achievement assures that there is at least some anchor to the price level. It rarely worked that way in practice, for several reasons:

  • Because of the unpredictability and instability of money demand, monetary aggregate targets rarely served to guide monetary policy execution. Monetary targets were rarely binding, since they were usually widely missed (Mexico) or overachieved (Korea, Thailand, Brazil). These errors were mostly due to surprises in money demand or net international reserves, the latter often the result of large errors in predicting capital flows (Mexico), and did not serve to indicate the adequacy of the monetary stance.13

  • Even if a money target is met, the exchange rate may still be subject to wide swings. These fluctuations, particularly during the panic-prone post-crisis period, risk feeding rapidly into expectations and being validated by balance sheet effects and wage and price-setting dynamics. Monitoring of monetary policy therefore needed to rely on indicators that were observable at high frequencies and bore a direct relationship to market conditions.14

  • The low interest elasticity of money demand in the short run implies that any attempt to strictly control the money supply in the short run tends to result in unbearably high or volatile interest rates (e.g., Turkey, for the first few days after its float). Nonetheless, monetary aggregates can still play a useful supportive role, particularly as objective “trip wires” for cases of egregious failure to conduct an appropriate monetary policy, as has been highlighted by Ghosh and others (2002).15

Inflation targeting has become a popular policy choice for floating exchange rate countries, including many emerging markets.16 However, after a crisis, full-fledged inflation targeting can rarely be put in place quickly. An exception was Brazil, where full-fledged inflation targeting could be implemented after only a few months.17 In other cases, particularly early in the crisis, it is difficult to forecast inflation with any confidence, in part because of residual doubts about the rest of the policy package. Investing the credibility of post-crisis institutions and policymakers in achievement of an inflation target was therefore seen as risky.

In most cases, the authorities exercised a fair amount of discretion in the conduct of monetary policy, taking into account the high-frequency behavior of a variety of indicators, such as expected inflation, the exchange rate, the level of activity, wage developments, and monetary aggregates. Some of these cases can usefully be characterized as having followed informal inflation targeting. In these cases the authorities’ monetary policy actions were largely guided by their stated inflation objective, although they did not have in place the full-fledged inflation-targeting apparatus of central bank accountability, transparency, and independence (Brazil until June 1999; Mexico, at least after 1995; Korea; Turkey). Others for many months after the initial stage maintained an eclectic monetary policy, with no clear nominal anchor (Thailand).

Countries varied in the emphasis they placed on the exchange rate in the conduct of monetary policy. Malaysia adopted a formal peg in mid-1998, several months after stability had largely been restored and when pressures had shifted toward appreciation. Other countries also gave substantial weight to the exchange rate as an indicator of the stance of monetary policy, particularly in the initial turbulent period, since it was the highest-frequency and most visible manifestation of the state of nominal stability and monetary policy credibility. When a large degree of de facto dollarization exists, it may make sense to attach a special importance to the exchange rate, given high pass-through to inflation and potential balance sheet effects. Nonetheless, de facto exchange rate targeting is rarely possible or advisable after a crisis, given the vulnerability to speculative attack it presents.18

The most important instruments of monetary policy in a floating exchange rate regime are open market operations that influence the level of the domestic interest rate. In cases where domestic money markets were not well developed or were seriously disrupted (Russia, Indonesia, Malaysia), other instruments were necessary, such as unsterilized foreign exchange intervention, manipulation of reserve requirements on bank deposits, and direct changes in the central bank’s discount rate.

Sterilized foreign exchange market intervention has also been an important instrument, particularly in the immediate post-crisis period. The closing of the U.S. dollar financing gap typically required not just an adequate supply of dollars “on paper” but substantial sterilized foreign exchange market intervention as well, particularly in the immediate post-crisis period, after the complete policy package had been put in place but before it had become fully credible. Although many countries lost large amounts of reserves both in defending the peg and in the immediate aftermath of the float in ineffectual but costly bouts of sterilized intervention, some limited sterilized intervention may usefully complement an appropriate policy package. In the initial phase, before confidence has returned but after appropriate policies have been put in place, sterilized intervention has helped to accommodate capital outflow until confidence returned.

Foreign exchange has also effectively been provided by indirect means, acting as the equivalent of sterilized intervention. In several cases (Mexico, Korea, also Brazil in 2002), the central bank provided U.S. dollar loans to local banks at a predetermined U.S. dollar interest rate. This lending, and the redemption of dollar-indexed government liabilities directly in U.S. dollars (Mexico), is similar in its effects on the foreign exchange market to sterilized interventions through the foreign exchange market: the central bank accommodates a demand for U.S. dollars in a way that avoids pressures on the foreign exchange market and does not directly change the money supply or domestic interest rates.19

Figure 4.1 (bottom panel) illustrates the role played by U.S. dollar lending during the stabilization phase of the Mexico crisis. The line labeled “central bank lending to banks” shows the stock of direct U.S. dollar-denominated lending by the central bank to the banking system. It illustrates several points. First, the quantity of U.S. dollars provided was substantial, reaching $3.5 billion in early April. Second, net dollar lending continued in substantial quantities for several weeks beyond the critical mid-March point at which stability had begun to return. Finally, the U.S. dollars lent through this window were recovered quickly; this was not a sustained outflow.20

After the initial period during which nominal stability is first established, large-scale interventions to accommodate capital outflows do represent a sign of failure. Indeed, a more typical experience has been for countries to intervene substantially on the buying side later in the post-crisis period, buying U.S. dollars to rebuild international reserves as foreign capital begins to return rapidly, or the current account swings strongly into surplus (Korea, Russia), or both. Prolonged large reserve outflows suggest an inherently futile attempt to substitute provision of U.S. dollars for an adequate overall policy stance. However, even several months or years into the still highly uncertain post-crisis environment, relatively small-scale and intermittent intervention can be a useful tool, particularly in rare moments of panic (Brazil, Mexico in late 1995) and when accompanied by appropriately high interest rates (as discussed in the preceding section).

The monetary authorities in post-crisis countries should be encouraged to quickly devote attention to solidifying and clarifying their monetary policy framework. Most countries that chose to float had trouble articulating and implementing clear strategies and tactics for monetary policy in the aftermath of crises. Some delay in choosing a clear nominal anchor in the aftermath of a crisis is understandable and perhaps inevitable, given the uncertainties surrounding the overall policy framework in the first few months after the crisis.

Nevertheless, the situations where the authorities either have no clear framework (Thailand) or claim that they are money targeting when they are not (Mexico) cannot be conducive to the fastest possible return to monetary policy credibility. The eclectic approach may be sufficient for countries with a strong history of monetary policy credibility, such as Thailand. Countries in Latin America are more likely to benefit from a more explicit strategy, owing to past bouts of high inflation and hence relatively low central bank credibility. For example, it may be helpful to recognize that while aggregates are useful guides to monitoring monetary policy, they are not generally useful in describing or conducting monetary policy. The examples in the sample suggest that, for most countries in Latin America that float, informal inflation targeting moving to full-fledged inflation targeting would appear to be the best choice.

Institutional Reforms to Promote Monetary Policy Credibility

The reforms that can most directly enhance monetary policy credibility after a crisis are changes in the central bank law (or the constitution) and organizational restructuring of key agencies involved in financial sector supervision. (Appendix 4.2 reviews institutional reforms enacted post-crisis to enhance monetary policy credibility in some of the cases examined here.) Monetary policy must be separated from the needs of the private sector or the government for U.S. dollars and from the problems resulting from widespread insolvency in the banking sector. This normally requires concerted action by the government and the legislature, not just (or even necessarily) the central bank, and it is often accompanied by institutional reforms.

  • Many countries undertook institutional reform to handle banking system insolvency by creating new institutions, either in the central bank or as separate agencies capitalized or funded by the government.

  • Some countries off-loaded banking supervision from the central bank. Others did not, on the reasonable grounds that the expertise and resources still lay with the central bank.

  • Some countries enacted measures to limit central bank financing of the government.

It is possible in many instances to stabilize monetary and exchange rate policies effectively without solving institutional weaknesses, even those that contributed to the crisis. Indeed, after a crisis, when institutions have typically just failed dramatically, actual performance may be more important than institutional and especially legal reform in cementing positive expectations.

  • Thailand did not make most of the changes in the structure of its central bank law that would have formally increased its central bank’s autonomy. It nonetheless was able to restore monetary policy credibility. (A long history of inflation credibility and a new government certainly helped here.)

In some cases, full-scale and up-front institutional reform of the monetary policy framework can be necessary. Where the failure of the previous monetary regime was most dramatic, full-scale institutional reform of the monetary policy framework and the central bank in the immediate aftermath of the crises was warranted (Bulgaria, Ecuador). In other cases, where monetary policy has lost credibility (e.g., because of a failed defense of an explicit peg), reforms to help focus expectations on future performance rather than past failures have been helpful.

It is important not to rush institutional and legal reform in a crisis or to reform institutions myopically. Legal and institutional changes are for the long run and can take time to design and implement properly; it is vital to get the new institutions right the first time.21 Moreover, it is possible to move too soon on institutional reform. In the post-crisis turmoil, monetary policies may be pursued that would not be appropriate once normality has been restored. It may not be helpful to the credibility of new institutions to ask them to carry out these unusual policies. For example, where there is a necessary adjustment in the exchange rate (for reasons of overvaluation, for instance) or even the price level (in the context of the need to resolve a banking crisis, for example), the usually desired single focus of monetary policy on price stability must temporarily change (Bulgaria).

However, if the necessary legal and institutional changes are delayed too long or abandoned, this can come back to haunt the country in the future. Thus, the post-crisis period is one that can usefully be taken advantage of to pursue good long-run reforms. For example, the Central Bank of Brazil enjoyed de facto independence in the conduct of monetary policy. However, seating certain aspects of this independence in the law, in particular by staggering terms for the board, would have reduced uncertainty during the presidential election campaign about the future actions of the central bank.

Concluding Remarks

The key conclusions of this analysis, based on the review of experience we have undertaken, are as follows:

  • Monetary policy alone cannot close the financing gap.

  • Floats bring nominal stability quickly in countries with low pre-crisis inflation; hard pegs have been at least narrowly successful for countries in deeper disarray.

  • Targeting of money aggregates will rarely serve as a coherent framework for floats; informal or formal inflation targeting offers more promise.

  • Early and determined tightening brings nominal stability and does not appear more costly for output.

Appendix 4.1. Frameworks of Monetary Policy in Crisis Countries

Table 4.2 reports on the post-crisis framework of monetary policy in the countries of the sample. The table presents information—for the various phases of the crises examined—on duration, final and intermediate targets or goals of monetary polilcy, policy instruments, and IMF program targets.

Table 4.2.

Monetary Policy Frameworks in Crisis Countries

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Sources: IMF staff reports, IMF Staff Country Reports; government Letters of Intent; IMF technical assistance reports; and government central bank reports, as well as Reinhart and Rogoff (2002) and Hernandez and Montiel (2001) for exchange rate arrangements; Edwards and Savastano (1998) and Carstens and Werner (2000) for Mexico; Gulde (1999) and Enoch, Gulde, and Hardy (2002) for Bulgaria; Enoch and others (2001) for Indonesia; and Boorman and others (2000), Lane and others (1999), Lindgren and others (1999), and Ghosh and other (2002) for various cases.

According to IMF staff, demand for base money in February 1999 may have been boosted by a flight to liquidity at the end of January, prompted by rumors of a possible asset freeze (which would not have applied to demand deposits), as well as by seasonal factors, notably the carnival holidays.

For example, there was an understanding in early 1998 that the authorities would not reduce interest rates until the exchange rate had substantially appreciated back to W 1,400 per dollar, though there was no explicit commitment to raise rates until that could be achieved. Money and credit aggregates were not useful given shifting market conditions, particularly for day-to-day policymaking, because of lags in measurement and uncertainty about money demand. There was also substantial uncertainty about required real exchange rate adjustment, so money and NDA may have served to warn if the program were well off-track. In the event, reserve money was well below program levels at end-March and end-June 1998. Meanwhile, Korea substantially overperformed on NIR (and thus NDA), which was thus also not a binding constraint on monetary policy.

The authorities have not moved to inflation targeting earlier due to a belief that high inflation and ongoing fiscal problems made a clear commitment to hit a particular inflation target too risky, and because of a need to improve inflation forecasting techniques; set up procedures for implementation, transparency, and accountability; and prepare public opinion.

The effort to freeze the money base resulted in extremely high interest rates (some 10,000 percent annualized) in an almost totally frozen market. Rolling overnight claims were resulting in huge transfers to creditors and away from state banks. The exchange rate continued to depreciate anyway.

Appendix 4.2. Institutional Reform for Monetary Policy Credibility in Selected Crisis Cases

This appendix reviews experience with the role of central bank credibility—or lack thereof—in shaping crisis response, and of post-crisis institutional reform in enhancing credibility.22

Inadequacies in the legal and institutional frameworks governing central banks may not have caused the recent financial crises in Asia and elsewhere, but these weaknesses have—to varying degrees—facilitated and amplified the problems. Factors that negatively affected central bank performance include: (1) insufficient political and financial autonomy; (2) numerous and conflicting objectives; (3) insufficient authority and powers to achieve these objectives; and (4) inadequate central bank accountability.

Asian Crisis

It is generally accepted that inadequate financial supervision was in part to blame for the weak financial systems of the countries affected by the Asian crisis. Other crisis factors involving the central bank were the defense of unsustainable exchange rate pegs and extensive financial support to insolvent financial institutions. The problems created by central bank actions reflected in part that the central banks had to pursue conflicting objectives, which they failed to achieve simultaneously. Some of these failures were the direct result of undue government interference with central bank decisions. The success of efforts to reform the legal and institutional framework of these central banks so as to avoid recurrence of such problems has been mixed.

Thailand. The 1997 crisis, which was primarily caused by an unsustainable exchange rate that led to the depletion of central bank reserves in support of the baht, also revealed weak prudential supervision by the Bank of Thailand. Main shortcomings involved the practice of providing financing to insolvent financial institutions while delaying closure or restructuring decisions. Substantial liquidity support was provided through the Financial Institutions Development Fund (FIDF), which was financed primarily from government-guaranteed bonds and Bank of Thailand resources; such financing was found to be a major contributor to Thailand’s exchange market pressures. In the context of the StandBy Arrangement approved by the IMF on August 20, 1997, the authorities committed to implement measures to initiate a credible and up-front restructuring of the financial sector, isolate and liquidate insolvent financial institutions, and conduct strict control over monetary expansion. Amendments to central bank legislation were not a performance criterion under the IMF program, but were policy commitments assumed by Thailand’s Letters of Intent and Memoranda of Economic and Financial Policies.23

Despite several IMF missions to review the ongoing preparations of amendments to the Bank of Thailand Act and to the Currency Act called for under the authority’s program, no amendments had been passed as of this writing.24

Indonesia. The central bank’s failure to pursue price stability was exacerbated by the financing it provided to the financial sector. Government pressure in this regard was a particularly important factor: under the 1968 central bank legislation, all Bank of Indonesia decisions were subject to the approval of a Monetary Council chaired by the Ministry of Finance and formed by other ministers of the government. Amendments to the 1968 legislation with a view to institutionalize the central bank’s autonomy formed a core element of the 1997 IMF Stand-By Arrangement (see Indonesia’s October 31, 1997 LOI, available on the Internet at http://www.imf.org/external/np/loi/103197.htm; and IMF, “IMF Approves Stand-By Credit for Indonesia,” Press Release 97/50, November 5, 1997, at http://www.imf.org/external/np/sec/pr/1997/pr9750.htm). As a result, a new Bank of Indonesia Act was enacted on May 17, 1999, that established the central bank as an independent entity free from government interference and solely responsible for the formulation and implementation of monetary policy. Under the 1999 law, the Bank of Indonesia’s main objective is to achieve and maintain the stability of the rupiah, and other responsibilities, including banking regulation and supervision, are spelled out as tasks for achieving Bank of Indonesia’s main objective. The law provides for the transfer of responsibilities in banking supervision to a separate entity to be established no later than December 2002 (now extended to December 2003). After the passage of the 1999 Bank of Indonesia Act, the need for strengthening the Bank of Indonesia accountability regime without compromising the central bank’s independence was identified, and proposals were made for amending the law (but no such amendments had been passed as of this writing).

Korea. The financial system was undermined by excessive government interference in the economy, inadequate sequencing of capital account liberalization, and the lack of prudential regulation that should accompany liberalization. At the time, the government had considerable influence over the Bank of Korea, in particular through the Minister of Finance as the Chairman of the Bank of Korea’s Monetary Board, its main decision-making body. As part of its IMF-supported program (see Korea’s December 3 and 24, 1997 LOIs, available on the Internet at http://www.imf.org/external/np/loi/120397.htm and http://www.imf.org/external/np/loi/122497.htm, respectively; see also IMF, “IMF Approves SDR 15.5 Billion Stand-by Credit for Korea,” Press Release 97/55, December 4, 1997, at http://www.imf.org/external/np/sec/pr/1997/pr9755.htm, and IMF, “Korea Strengthens Economic Program; IMF to Activate Additional Financial Support,” News Brief 97/32, December 24, 1997, at http://www.imf.org/external/np/sec/nb/1997/nb9732.htm), the government committed to seek early passage of legislation to make the Bank of Korea independent and with price stability as its overriding mandate. It further committed to consolidate all supervisory functions under one agency with operational independence and adequate resources. The December 31, 1997 amendments to the Bank of Korea Act fell short of important IMF recommendations but constituted an overall improvement of Bank of Korea’s independence. Effective April 1, 1998, the responsibilities for all financial sector supervision were moved to a new agency, the Financial Supervisory Commission/Financial Supervisory Service, which, for the first time, ensured that all depositary institutions, including those over which the Bank of Korea had not had authority, were supervised effectively and on the same basis.

Other Countries

Turkey. Inflation in Turkey averaged close to 80 percent per year in the 1990s, after 25 percent in the 1970s and 50 percent in the 1980s. Although monetary financing of government deficits by the Central Bank of Turkey was identified as the ultimate cause of inflation, no commitments for reform of the legal framework for the Central Bank of Turkey, in particular a prohibition on credit to the government, were included as program conditionality. The creation of base money was contained through a quantitative performance criteria on net domestic assets. However, the December 18, 2000 LOI (available on the Internet at http://www.imf.org/external/np/loi/2000/tur/03/index.htm)—in the context of the combined third and fourth reviews and the first augmentation of the Stand-By Arrangement—provided for the adoption of a new central bank law by end-April 2001 “with the goal of designating price stability as the primary monetary policy objective of the Central Bank of Turkey, enhancing its operational independence in the pursuit of that objective, increasing its degree of accountability for monetary policy decisions, and enhancing the transparency of monetary policy formulation” as a condition (i.e., prior action) for the eighth review under the program. The new central bank law was adopted in April 2001. It prohibits Central Bank of Turkey credit to the government, provides for price stability as the primary objective for the Central Bank of Turkey, and establishes operational independence for the Central Bank of Turkey (including the establishment of a monetary policy committee). A new Banking Act had been passed in 1999, and the supervisory powers of the Central Bank of Turkey and the Treasury had been shifted to the newly created Banking Regulation and Supervision Agency, which became operational on September 1, 2000.

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1

Inputs to this section were also provided by Tonny Lybek.

2

Dates in parentheses refer to the year in which the crisis began.

3

Table 4.1 gives the starting dates for the crisis cases considered, as well as how many months it took for the nominal exchange rate to stop depreciating and for volatility to reach levels typical of stable floating exchange rates. The dating of the beginning of the crisis is somewhat arbitrary, particularly for those countries in which the crisis involved a more gradual loss of nominal control (Bulgaria, Ecuador). See Berg and others (2003) for a summary of the key developments and economic indicators for each of the cases.

4

In cases where dollar-denominated liabilities are a high proportion of the total, even substantial depreciation of the currency and accompanying inflation—one possible way of resolving the interest rate trade-off on domestic-currency-denominated debt— will not work because it also raises the probability of default.

5

All the cases reviewed here had generally open capital accounts. The implementation of new capital controls during the crisis was highly problematic. Capital controls have proven largely ineffective in situations when nominal stability had not already largely been restored (Thailand, Russia). They did not stop the exchange rate collapse and indeed may have promoted further capital outflow, at least in the short run. Malaysia introduced selective capital controls on a temporary basis in September 1998, after initial stabilization had been achieved, accompanied by a currency peg set at a significantly undervalued level. See Meesook and others (2001).

6

Reinhart and Rogoff (2002) characterize uncontrolled depreciations as “freely falling” exchange rate regimes to distinguish them from more functional floats.

7

Figure 4.2 demonstrates these conclusions by showing levels of the exchange rate, interest rates, and inflation for an average of Brazil, Korea, Malaysia, and Thailand. Mexico and Indonesia are excluded because the timing of their exchange rate trajectories is sufficiently different to obscure the implications of the average, but their outcomes are qualitatively similar. Berg and others (2003) provide figures showing real and nominal exchange rates, inflation, and interest rates for each of the countries in the sample.

8

Russia also had an incomplete disinflation, reflecting its decision to maintain a highly depreciated level of the nominal exchange rate after initial stabilization. Turkey, a country that like Bulgaria and Ecuador had a recent history of high inflation, also benefited from a relatively small nominal appreciation despite having floated its currency. This suggests that that history, as well as the type of exchange rate regime chosen, shapes the path of disinflation.

9

Berg and others (2003) give data on these variables for each country in the sample.

10

This is consistent with evidence in Goldfajn and Gupta (1999) on monetary policy after crises, and Borensztein and De Gregorio (1999), Goldfajn and Werlang (2000), and Choudhri and Hakura (2001) on inflation pass-through in developing countries. One important conclusion of this research is that exchange rate depreciation beyond levels that are consistent with some definition of long-run equilibrium (for example, defined simply as the value associated with the long-run trend real exchange rate) is particularly inflationary. Lindgren and others (1999) and Ghosh and others (2002) contain fuller discussions of the evidence on the relationship between exchange rates and monetary policy in the post-crisis environment. Newer work by Christiano, Gust, and Roldos (2002) and Caballero and Krishnamurthy (2002) tends to support the view, expressed in Ghosh and others (2002), that tight monetary policy is likely to be necessary after a crisis.

11

Where financial system vulnerabilities result mostly from excess domestic leverage rather than from liability dollarization, it may be more appropriate to keep interest rates lower and allow a larger depreciation (Malaysia).

12

The goal is the ultimate objective of policy, such as stable prices and output close to its potential level. Intermediate targets are more immediately observable indicators of whether policy is adequate, such as the inflation forecast or monetary aggregates. Operating targets, such as interest rates or the exchange rate, are directly achievable by the central bank on a regular basis. Instruments, such as open market operations and foreign exchange market intervention, are means to achieve operating targets.

13

Increasing dollarization was an important factor making money demand hard to predict in Turkey, although the issue is more general.

14

Ghosh and others (2002) emphasize this point. Carstens and Werner (2000) are revealing about the futility of Mexico’s short-lived experience with money aggregate targeting in early 1995. See also Edwards and Savastano (1998).

15

Indonesia may represent something of an exception to the rule that monetary aggregates did not help to guide policy. For a few key months in 1998, at least, base money did actually track targets quite closely. Two special factors may have been important here. First, Indonesian monetary policy credibility, and the level of the rupiah, had fallen to an extremely low point by April/May 1998, even relative to the other cases considered here, when the monetary aggregate ceilings started to bind effectively. In this context, even a crude policy of keeping aggregates constant was a major improvement. Second, the shocks that called for a contractionary monetary policy during this period tended to cause flight from bank deposits into rupiah cash, hence increases in money demand. Hence, a monetary aggregate target tended to at least give the correct sign to the policy response. In more typical cases, negative shocks may sometimes reduce cash demand, in which case a money aggregate target might well give the wrong sign for the policy response.

16

In its full-fledged form, inflation targeting involves (1) the public announcement of medium-term numerical targets for inflation; (2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated; (3) an information-inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; (4) increased transparency of the monetary policy strategy through communication with the public and the markets; and (5) increased accountability of the central bank for attaining its inflation objectives. For discussions of inflation targeting in emerging markets, see Mishkin (2000), which contains this definition, as well as Masson, Savastano, and Sharma (1997), and Carare and others (2002), and the many references cited therein.

17

Brazil also stands out as the only country in the sample that did not suffer a banking crisis along with the currency crisis. This was surely an important factor in permitting the authorities to create the new monetary policy framework, and indeed to stabilize, as quickly as they did.

18

Russia represents an intermediate case. It heavily managed its float in 1999 with months of exchange rate stability interrupted by adjustments of the level, achieved in part through substantial intervention. Toward the end of the year, it moved to a de facto crawling peg. The emphasis on the exchange rate was facilitated by (1) its decision to maintain a highly depreciated level of the exchange rate; (2) the fact that its prior default had rendered it somewhat less vulnerable to further attack; and (3) strong fiscal performance, greatly abetted by the sharp rise in the price of oil in the post-crisis period.

19

A difference is that unlike sterilized intervention, the central bank incurs no foreign exchange risk.

20

As the Korean and Mexican examples illustrate, monetary policy is often tightened simultaneously with the intervention. We could, as a manner of terminology, call these interventions partially sterilized. It is useful to distinguish the monetary policy and intervention choices, however, for several reasons. First, in practice, the decision about what to do with monetary policy was a separate one from the decision to intervene (and sterilize). In the Mexico example, the dollars were simply lent directly; there was no automatic domestic monetary impact. More generally, monetary policy was typically conducted in terms of interest rate rules, so that foreign exchange interventions were automatically sterilized. Second, the local currency value of foreign exchange interventions often dwarfed the reductions in the money base associated with a monetary policy contraction. Thus, the measured share of the intervention that was sterilized was usually very large, even when the associated monetary contraction was important when measured in terms of interest rates.

21

A fuller overview of what have now become standard recommendations can be found in Lybek (1998).

22

The main authors of this appendix were Bernhard Steinki and Gabriela Rosenberg.

23

Starting with the November 25, 1997 LOI/MEFP (available on the Internet at http://www.imf.org/external/np/loi/112597.htm) and repeated in connection with program reviews, Thailand’s authorities expressed their intentions to “amend the Currency Act in order to modernize the regulatory framework for central banking operations.” In the LOI/MEFP dated May 26, 1998 (available on the Internet at http://www.imf.org/external/np/loi/052698.htm) the authorities set out their plan to review the central bank, commercial bank, and finance company laws by October 1998, and to obtain cabinet approval of the necessary amendments by December 31, 1998. They also noted their intention to amend the Currency Act by October 31, 1998.

24

The IMF’s recent July 12, 2002 Article IV consultation discussions underscored that an early passage of a revised Bank of Thailand Act and the Currency Act to enhance the operational independence of the central bank would strengthen the effectiveness of Thailand’s monetary policy. See IMF, “IMF Concludes 2002 Article IV Consultation and Post-Program Monitoring Discussions with Thailand,” Public Information Notice 02/94, August 29, 2002 (available on the Internet at http://www.imf.org/external/np/sec/pn/2002/pn0294.htm).

Recent Experience and Lessons for Latin America