Re-Establishing Credible Nominal Anchors After a Financial Crisis
A Review of Recent Experience
Author:
Mr. Alessandro Zanello
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,
Mr. Mark R. Stone
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Mr. Christopher J. Jarvis
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Mr. Andrew Berg
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Contributor Notes

Authors’ E-Mail Addresses: aberg@IMF.org; cjarvis@IMF.org; mstone@IMF.org, azanello@IMF.org
Publication Date:
01 Apr 2003
eISBN:
9781451849899
Language:
English
Keywords:
WP; exchange rate; country; government; monetary policy credibility; aftermath; real value; monetary policy tightening; nominal exchange rate; exchange rate volatility
Download PDF (1.2 MB)

This paper studies the question of how to achieve monetary policy credibility and price stability after a financial crisis. We draw stylized facts and conclusions from ten recent cases: Brazil (1999); Bulgaria (1997); Ecuador (2000); Indonesia (1997); Korea (1997); Malaysia (1997); Mexico (1994), Russia (1998); Thailand (1997); and Turkey (2001). Among our conclusions, highlights include: (i) monetary policy alone cannot stabilize; (ii) floats bring nominal stability quickly in countries with low pre-crisis inflation and hard pegs have been at least narrowly successful for countries in deeper disarray; (iii) in floats, early and determined tightening brings nominal stability and does not appear more costly for output; (iv) monetary aggregate targeting rarely serves as a coherent framework for floats; informal or full-fledged inflation targeting offers more promise.

Abstract

This paper studies the question of how to achieve monetary policy credibility and price stability after a financial crisis. We draw stylized facts and conclusions from ten recent cases: Brazil (1999); Bulgaria (1997); Ecuador (2000); Indonesia (1997); Korea (1997); Malaysia (1997); Mexico (1994), Russia (1998); Thailand (1997); and Turkey (2001). Among our conclusions, highlights include: (i) monetary policy alone cannot stabilize; (ii) floats bring nominal stability quickly in countries with low pre-crisis inflation and hard pegs have been at least narrowly successful for countries in deeper disarray; (iii) in floats, early and determined tightening brings nominal stability and does not appear more costly for output; (iv) monetary aggregate targeting rarely serves as a coherent framework for floats; informal or full-fledged inflation targeting offers more promise.

I. Introduction

The question addressed in this paper 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. We draw stylized facts and conclusions from ten of the most important recent cases: Brazil (1999); Bulgaria (1997); Ecuador (2000); Indonesia (1997); Korea (1997); Malaysia (1997); Mexico (1994), Russia (1998); Thailand (1997); and Turkey (2001).

Methodologically, we assume that these crises are sufficiently similar to each other that we can learn something of general interest from a joint analysis of several of them. However, we do not attempt panel regressions or other statistical analyses, on the grounds that our cases are too few and we prefer to dwell on the idiosyncratic features of each one rather than assume them away.

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.1 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 can be seen as ending when a new anchor is credibly entrenched.

Our main concern is how monetary policy itself can help achieve nominal stability. However in Section II we first examine the prerequisites for a credible nominal anchor. Section III discusses experience with post-crisis exchange rate regimes, noting that most countries in the sample choose to float, though two chose hard pegs. Section III examines the conduct of monetary policy in the floating exchange rate countries, focusing on the question of how much to tighten policy. Section IV looks at the framework for monetary policy in a float, in other words, the set of goals, targets, and instruments that guide policy. Section V concludes.

II. Prerequisites For Nominal Stability

This section focuses on the prerequisites for nominal stability over and above monetary policy. The experience of the countries in our sample is that a credible monetary policy can only be arrived at if two supporting conditions are met.

The first condition is elimination of an ex ante dollar shortage. 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 achieve 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 caused by the dollar shortage 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.”2 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 crisis months. 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.

The second condition is the solution of 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 Chapter 6 of Collyns and Kincaid (2003), forthcoming)). 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. However, in some cases, 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 had to essentially 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 (print money).

Figure 1 illustrates the complementary role of strong policy packages and adequate 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 inter-bank 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 Fund 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 1.
Figure 1.

Putting Together the Package

Citation: IMF Working Papers 2003, 076; 10.5089/9781451849899.001.A001

III. Post-Crisis Exchange Rate Regimes

Currency crises are marked by either the forced abandonment of a fixed exchange rate regime or a sharp depreciation in a floating one, often accompanied by a substantial loss of reserves. Thereafter, countries must choose whether to continue the float or adopt another post-crisis exchange rate regime. Most countries in our sample were able to stabilize fairly quickly with a floating exchange rate. Two cases of especially deep disarray culminated in decisions to adopt hard pegs, which also led to a rapid stabilization.

Given the loss of credibility, countries with a relatively open capital account have only two choices for exchange rate regime in the immediate aftermath of a crisis: (i) some variant of a float or (ii) 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.3

Most countries studied succeeded in achieving nominal stability with a floating exchange rate regime. While 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 pre-crisis. In most cases that floated, the nominal and real exchange rates ceased to depreciate and exchange rate volatility also fell sharply (Table 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.4 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 five percent within two years. Furthermore, in most cases two years after the crisis average inflation was below its pre-crisis level (Table 1 and Figure 2).5 6

Figure 2.
Figure 2.

Floaters and Fixers

Citation: IMF Working Papers 2003, 076; 10.5089/9781451849899.001.A001

1/ Average inflation was negative between t+16 and t+20, so it does not display on the logarithmic right scale.2/ The floating regime countries are Brazil, Korea, Malaysia and Thailand. The fixed regime countries are Bulgaria and Ecuador.
Table 4.1.

Crisis Countries: Indicators of Recovery and Stabilization

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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 t0 + 17, since the crisis was relatively recent.

Inflation never fell below either 10 or 5 percent. Figures shown indicate inflation at t0 + 24.

On a nominal basis, the depreciation never really 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.

In most countries that floated, monetary policy moved to a float with inflation targeting (Mexico, Brazil, Thailand, Korea). Indonesia and Turkey are still moving in that direction. Section V below discusses this choice further. Russia moved to a de facto crawling peg in the context of gradually declining inflation. Finally, Malaysia, several months after initial stabilization under a float, pegged at a significantly undervalued level while at the same time introducing selective capital controls.

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 and/or other preconditions for nominal stability. 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, though 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, though 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, though inflation remained at higher levels than in countries that floated (Table 1; Figure 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.7

Hard pegs had both benefits and costs for the countries which adopted them. Adoption of the hard peg anchored expectations and therefore provided a context more conducive to the adoption of fiscal and banking reforms, though 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.

Finally, notwithstanding the faster decline in real interest rates, and the more rapid adoption of a firm nominal anchor to monetary policy, the pattern of output decline (and ensuing recovery) was broadly 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.

IV. The Post-Crisis Stance Of Monetary Policy in a Floating Regime

The countries that floated and were most successful at ending quickly 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.8

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 reverse overshooting and hence limit the subsequent inflation.9 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 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 (Figure 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 3.
Figure 3.

The Short-Term Dynamics of Monetary Policy

Citation: IMF Working Papers 2003, 076; 10.5089/9781451849899.001.A001

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 and/or excess absorption 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 dollar liabilities (Brazil, Indonesia, and Thailand), excessive exchange rate depreciation is dangerous in its effects on balance sheets and, when the government is the dollar borrower, on fiscal solvency.10

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, and 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 (Table 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 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.

V. The Framework for Monetary Policy in a Floating Regime11

Restoring credibility in the aftermath of a financial crisis requires setting up a monetary policy framework that helps anchor public expectations. A hard peg achieves this almost instantaneously, as 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 deploy a battery of instruments 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 there, 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. 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, money or net domestic assets (NDA) targets rarely served to guide monetary policy execution. Monetary targets were rarely binding, as 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

  • 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 results 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 very quickly. The 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, though 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 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 towards 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 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. While 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 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 dollar loans to local banks at a predetermined dollar interest rate. This lending, and the redemption of dollar-indexed government liabilities directly in 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 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 1 illustrates the role played by dollar lending during the stabilization phase of the Mexico crisis. The line labeled “Central Bank lending to banks” in the lower panel of Figure 1 shows the stock of direct dollar-denominated lending by the Central Bank to the banking system. It illustrates several points. First, the quantity of dollars provided was substantial, reaching $3.5 billion dollars 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 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 dollars to rebuild international reserves as foreign capital begins to return rapidly and/or the current account swings strongly into surplus (Korea, Russia). Prolonged large reserve outflows suggest an inherently futile attempt to substitute provision of 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 section IV above).

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.

VI. Concluding Remarks

Our main concern has been how monetary policy itself can help achieve nominal stability. However, we first examined the prerequisites for a credible nominal anchor and noted that the achievement of initial stability typically requires meeting two conditions, in addition to a sound monetary policy: (i) an ex ante dollar gap has to be closed; and (ii) the problems in the banking sector have to be solved without resorting to massive liquidity support. One of the implications of the first point is that monetary policy alone cannot close this financing gap through its effects on the balance of payments. Another is that sterilized intervention may be useful, particularly in the initial stabilization phase, before confidence has returned but after appropriate policies have been put in place.

With respect to the choice of exchange rate regime post-crisis, most of the countries stabilized under a floating exchange rate. Stabilization was attained relatively quickly once the above prerequisites had been met, particularly when inflation was low pre-crisis. A post-crisis exchange rate peg has proven feasible only at an undervalued exchange rate and after some stability has already been restored, and may be viable only in the context of capital controls which can be costly. Hard pegs have been at least narrowly successful for countries in deeper disarray. They established credibility quickly, in that they achieved rapid convergence of interest rates. Disinflation was much less complete, however, than in the floats, the output cost was not generally lower, and these countries may face an exit problem.

For floats, the question of how much to tighten policy has been controversial. We find that early and determined monetary policy tightening brings nominal stability and does not appear more costly for output. The countries that floated and were most successful at ending quickly the period of volatility were those that tightened early and sharply and that did not ease monetary policy until stability had clearly been restored. This resulted in a period of very high interest and, later, exchange rate appreciation, but this period was not generally prolonged, with nominal interest rates returning to pre-crisis levels or below in only a few months.

Most of the floating exchange rate countries moved toward some form of inflation targeting. We observe that while countries that chose to float did fairly well at establishing initial stability, they generally had some difficulty in establishing, communicating, and implementing over time a clear monetary policy framework, that is the set of goals, targets, and instruments for monetary policy. We conclude that monetary aggregate targeting will rarely serve as a coherent framework for floats. Informal or full-fledged inflation targeting offers more promise, particularly for countries such as many in Latin America with a history of poor policy credibility.

Clearly, many caveats apply. Most notably, we have based our analysis on a reading of just these ten cases. This allows us to consider some of the richness of each of these situations, but it limits the generality of the result. Moreover, it is perhaps harder to evaluate the relationship between our conclusions and the cases we examine than it might be with a statistical analysis applied to a panel of crises. Nonetheless, we hope we have provided enough background information on the cases for the reader to come to his or her own opinion.

APPENDIX I

Overview of Crisis Cases1

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Sources are IFS, various IMF staff reports, IMF staff country reports, government letters of intent, and IMF technical assistance reports, as well as Reinhart and Rogoff (2002) for exchange rate arrangements, Honohan and Shi (2000) for deposit dollarization data, Hemming, Kell, and Schimmelpfennig (2003) for fiscal data, Gulde (1999) and Enoch and others (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 others (2002) for various cases.

APPENDIX II

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 Monteil (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 others (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 1,400 won 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. Meanwhile, Korea substantially over performed 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 was resulting in huge transfers to creditors and away from state banks. The exchange rate continued to depreciate anyway.

APPENDIX III

UF1
UF1
UF1

Crisis Countries: Real and Nominal Exchange Rates and Inflation 1

Citation: IMF Working Papers 2003, 076; 10.5089/9781451849899.001.A001

1/ The real exchange rate is the CPI-based bilateral real exchange rate against the dollar or, for Bulgaria and Turkey, the Deutchmark/Euro.It is measured as a deviation from a trend, which is calculated using data from January 1970, except for Brazil (December 1979), Bulgaria (January 1991) and Russia (December 1994). The nominal exchange rate is presented in terms of local currency units per US dollar.Source: IMF Staff Estimates

APPENDIX IV

UF2
UF2
UF2

Crisis Countries: Interest Rates, Exchange Rates and Inflation 1/

(In percent)

Citation: IMF Working Papers 2003, 076; 10.5089/9781451849899.001.A001

1/ t0 corresponds to the month before the first major movement of the exchange rate.2/ For Turkey, the latest observation is t+17, since the crises was relatively recent.Source: IMF Staff Estimates.

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  • Caballero, Ricardo, and Arvind Krishnamurthy, 2002, “A ‘Vertical’ Analysis of Monetary Policy in Emerging Markets,” unpublished working paper. Available at http://web.mit.edu/caball/www/.

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  • Carare, Alina, Andrea Schaechter, Mark Stone, and Mark Zelmer, 2002, “Establishing Initial Conditions in Support of Inflation Targeting,” IMF Working Paper 02/102 (Washington: International Monetary Fund).

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  • Carstens, Agustin, and Alejandro Werner, 2000, “Mexico’s Monetary Policy Framework under a Floating Exchange Rate Regime,” Monetary Affairs, Vol. 13 (July-December), pp. 113-650.

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  • Choudhri, Ehsan, and Dalia Hakura, 2001, “Exchange Rate Pass-Through to Domestic Prices: Does the Inflationary Environment Matter?,” IMF Working Paper 01/194 (Washington: International Monetary Fund).

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  • Chung, Chae-Shick, and Se-Jik Kim, 2002, “New Evidence on High Interest Rate Policy During the Korean Crisis,” in Korean Crisis and Recovery, ed. by David T. Coe, and Se-Jik Kimr (Washington: International Monetary Fund; Seoul: Korea Institute for International Economic Policy).

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  • Enoch, Charles A., Barbara Baldwin, Olivier Frecaut, and Arto Kovanen, 2001, “Indonesia-Anatomy of a Banking Crisis—Two Years of Living Dangerously, 1997–99,” IMF Working Paper 01/52 (Washington: International Monetary Fund).

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  • Ghosh, Atish, Timothy Lane, Marianne Schulze-Ghattas, Ales Bulir, Javier Hamann, and Alex Mourmouras, 2002, “IMF-Supported Programs in Capital Account Crises,” IMF Occasional Paper 210 (Washington: International Monetary Fund).

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  • Goldfajn, Ilan, and Poonam Gupta, 1999, “Does Monetary Policy Stabilize the Exchange Rate Following a Currency Crisis?,” IMF Working Paper 99/42 (Washington: International Monetary Fund).

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  • Lane, Timothy, Atish Ghosh, Javier Hamann, Steven Philipps, Marianne Schulze Ghattas, and Tsidi Tsikata, 1999, “IMF-Supported Programs in Indonesia, Korea, and Thailand, A Preliminary Assessment,” IMF Occasional Paper 178 (Washington: International Monetary Fund).

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  • Lindgren, Carl-Johan, Tomas Balino, Charles A. Enoch, Ann-Marie Gulde, Marc Quintyn, and Leslie Teo, 1999, “Financial Sector Crisis and Restructuring—Lessons from Asia,” IMF Occasional Paper 188 (Washington: International Monetary Fund).

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  • Masson, Paul R., Miguel A. Savastano, and Sunil Sharma, 1997, “The Scope for Inflation Targeting in Developing Countries,” IMF Working Paper 97/130 (Washington: International Monetary Fund).

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  • Meesook, Kanitta, Il H. Lee, Olin Liu, Natalia Tamirisa, and Yougesh Khatri, 2001, Malaysia: From Crisis to Recovery, IMF Occasional Paper 207 (Washington: International Monetary Fund).

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  • Stone, Mark, 2003, “Inflation Targeting Lite,” IMF Working Paper 03/12 (Washington: International Monetary Fund).

1

Table 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 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). Appendix I contains a summary of the key developments and economic indicators for each of the cases.

2

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.

3

All the countries in our sample had open capital accounts and most maintained them through the crisis. Post-crisis 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. Meesook and others (2001) review Malaysia’s experience.

4

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

5

Figure 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. Appendix III shows real and nominal exchange rates, inflation, and interest rates for each of the countries in our sample.

6

The success of the 1990s crisis countries in reducing inflation contrasts favorably with the difficulty which 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.

7

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 history, as well as the type of exchange rate regime chosen, shapes the path of disinflation.

8

Appendix IV shows these variables for each country in our sample.

9

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. Lane 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. More recent work by Christiano, Gust and Roldos (2002) and Caballero and Krishnamurthy (2002) tends to support the view, expressed in Ghosh et al (2002), that tight monetary policy is likely to be necessary after a crisis. There are also a variety of country studies such as Chung and Kim (2002) on Korea.

10

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).

11

Appendix II reports on the monetary policy framework post-crisis for each of the countries in our sample.

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, though the issue is more general.

14

Ghosh and others (2002) emphasize this point. Carstens and Werner (1999) are revealing on 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 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

It 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 and others (1997) and Carare and others (2002) and the many references cited therin. Stone (2003) discusses the move from informal to full-fledged inflation targeting.

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. Towards the end of 1999 it moved to a de facto crawling peg. The heavy emphasis on the exchange rate target was facilitated by (i) its decision to maintain a highly depreciated level of the exchange rate; (ii) the fact that its prior default had rendered it somewhat less vulnerable to further attack; and (iii) 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.

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Cover IMF Working Papers
Re-Establishing Credible Nominal Anchors After a Financial Crisis: A Review of Recent Experience
Author:
Mr. Alessandro Zanello
,
Mr. Mark R. Stone
,
Mr. Christopher J. Jarvis
, and
Mr. Andrew Berg
Volume/Issue:
Volume 2003: Issue 076
Publisher:
International Monetary Fund
ISBN:
9781451849899
ISSN:
1018-5941
Pages:
45
DOI:
https://doi.org/10.5089/9781451849899.001
Figure 1.

Putting Together the Package
Figure 2.

Floaters and Fixers
Figure 3.

The Short-Term Dynamics of Monetary Policy

Crisis Countries: Real and Nominal Exchange Rates and Inflation 1

Crisis Countries: Real and Nominal Exchange Rates and Inflation 1

Crisis Countries: Real and Nominal Exchange Rates and Inflation 1

Crisis Countries: Interest Rates, Exchange Rates and Inflation 1/

(In percent)

Crisis Countries: Interest Rates, Exchange Rates and Inflation 1/

(In percent)

Crisis Countries: Interest Rates, Exchange Rates and Inflation 1/

(In percent)