Summary by Leonardo Hernández

The IMF Institute hosted a high-level seminar on Exchange Rate Regimes during March 1920, 2001, to discuss optimal exchange rate systems for emerging market economies. The main conclusion was that optimal regimes vary across countries and through time as country circumstances change. Polar regimes—hard pegs and pure floats—can be equally viable alternatives if other policies and factors consistently support the exchange rate system, and, under specific circumstances, the middle ground may be a feasible option. The seminar agenda and a brief summary of the proceedings follow.

Round Table Discussion: Hard Peg or Free Floating?

Chair: Mohsin S. Khan (IMF)

Panelists: Stanley Fischer (IMF), Carmen Reinhart (University of Maryland), Jeffrey Frankel (Harvard University), and Robert Flood (IMF).

Exchange Rate Policy in Chile: Recent Experience

Felipe Morandé (Central Bank of Chile)

Mexico’s Experience with a Floating Exchange Rate

Alejandro Werner (Bank of Mexico)

Surprises on Israel’s Road to Exchange Rate Flexibility

Leonardo Leiderman (Deutsche Bank) and Gil Bufman (Tel Aviv University)

From Fixed to Floating: The Case of Poland

Ryszard Kokoszczynski (National Bank of Poland)

The Asian Countries Before and After the Crisis

Peter Montiel (Williams College) and Leonardo Hernández (IMF)

Argentina: The Experience with Hard Pegs

Guillermo Escudé (Central Bank of Argentina)

Hong Kong’s Experience in Operating the Currency Board System

Priscilla Chiu (Hong Kong Monetary Authority)

Hard Peg or Free Floating? The Case of Estonia

Peter Lohmus (Bank of Estonia)

The seminar on exchange rate regimes opened with an address by Horst Köhler, who stressed the importance of understanding better how the different regimes work—and what conditions are needed for them to work—in today’s highly integrated world. In briefly reviewing the recent experiences of several industrial and emerging market economies, he emphasized how different are the circumstances that each country group faces, and concluded that no single system can work for all countries at all times.

In the first session, participants at the round table discussed the critical role played by factors such as pass-through coefficients (Robert Flood, Carmen Reinhart); trade policy and the degree of financial integration (Jeffrey Frankel); a country’s capacity to issue foreign debt in its own currency (Carmen Reinhart); and its capacity to credibly commit to sound fiscal and monetary policies (Stanley Fischer). These factors explain why some countries, in recent years, have adopted either of the polar systems—hard peg or free float—while others have successfully maintained an intermediate regime. The factors that determine which system works better for a particular country became clear as different country experiences were analyzed and discussed during the seminar.

Chile and Poland were the only countries discussed at the seminar that have adopted free floats. Mexico declared a similar policy, but Alejandro Werner of the Bank of Mexico observed that, at times, the central bank has intervened in the market to smooth out exchange rate fluctuations. However, because these interventions are not targeted at the medium-term exchange rate, some would still characterize the regime as “floating.”

Felipe Morandé of Chile and Alejandro Werner both acknowledged that their countries’ choices to float their exchange rates were, to a great extent, dictated by the failure of prior monetary systems to deliver stability and sustained growth. In both countries, the last experiences with pegs ended in recession and financial crisis—Chile in 1982-83 and Mexico in 1995.

After 1983, the regime in Chile evolved into a crawling band that targeted the real exchange rate and resulted in a period of high and sustained growth that lasted until the Asian crisis in 1997. During this period, the country successfully introduced inflation targeting, but the increased financial integration and large capital inflows of the 1990s made it difficult to target both the real exchange rate and inflation. Thus, the adoption of a free float in 1999 reflected the recognition that it was impossible to pursue both independent monetary and exchange rate policies. Mexico adopted a free float in December 1997.

In Chile, and to a lesser extent in Mexico, four factors influenced the authorities’ hands-off policy after adopting a free float: pass-through coefficients fell rapidly in subsequent years, inflation stayed at relatively low levels, volatility in financial markets did not increase, and the corporate sector showed greater caution in managing its foreign indebtedness.

In Poland, the nominal exchange rate was managed in the early 1990s, to both maintain a competitive edge in the markets and to reduce inflationary pressures. According to Ryszard Kokoszczynski, however, the conflict between these two objectives became evident early on, and the authorities decided in favor of the first objective. The change in the international environment in the mid-1990s led to large capital inflows, a strong current account, and reserves accumulation, thus making the need to maintain a competitive real exchange rate less urgent. These developments allowed the authorities to adopt price stability as the primary objective, adopting in 1995 a crawling, but widening, exchange rate band. After introducing inflation targeting in 1998, the Polish economy, in reality, functioned with two nominal anchors. The adoption of a full float in early 2000 was recognition that a dual nominal system is unsustainable in the medium-term.

Since 1991, Israel has been operating a crawling band under an inflation targeting policy, but inconsistencies between the two objectives have forced the authorities to keep widening the band—as of late 2000, the band width surpassed 35 percent and has kept increasing since then. Gil Bufman and Leonardo Leiderman noted that four factors contributed to the decision to move toward greater exchange rate flexibility. First, the surge in capital inflows during the 1990s made the continuation of the dual nominal system increasingly costly. Second, the increased flexibility did not lead to more market volatility. Third, inflation and the pass-through coefficient both continued falling after exchange rate flexibility increased. And fourth, market participants have shown greater prudence in handling their external borrowing.

Korea, Indonesia, the Philippines, and Thailand all moved toward greater exchange rate flexibility in the postcrisis period, but Peter Montiel and Leonardo Hernández argued that none of these countries can be labeled “true” floaters for two reasons: their significant accumulation of reserves since the crisis and a lesser reliance on exchange rate movements in response to shocks than real floaters like Japan and Germany. The movement toward greater but limited flexibility in these countries can be justified on at least two grounds. First, they may be trying to target an undervalued currency to help the recovery. Second, they may be attempting to accumulate a reserve buffer as insurance against future liquidity shocks in international capital markets. Furthermore, these countries’ postcrisis policies could be characterized as second-best policies that are called for in view of market distortions that cause moral hazard and similar problems. The benign market response to these countries’ policies in the postcrisis period suggests that, under some conditions, there is still limited room to maneuver in the middle ground.

Argentina, Estonia, Hong Kong, and Malaysia adopted hard pegs, although for different reasons. Malaysia was the only one among the Asian crisis countries not to move toward greater flexibility after the 1997-98 turmoil. Peter Montiel argued that this policy was probably motivated by the authorities’ decision not to resort to an IMF-sponsored adjustment program, which made the credibility issue vis-à-vis financial markets a pressing one. He noted that the authorities signaled a very strong commitment to price stability by pegging their currency, and resorted to capital controls in order to have some “breathing space” to implement monetary policy. Again, the benign market response postcrisis suggests that the policy mix has been adequate given the specific circumstances.

Argentina, Hong Kong, and Estonia operate currency boards, which indicates a much greater commitment to the peg. Argentina adopted its currency board in 1991 in an effort to escape hyperinflation after a long history of failed stabilization programs. The currency board succeeded in stabilizing prices and bringing about a period of prosperity when foreign capital flooded in, but the board also acted as a straightjacket when external conditions changed. Nevertheless, Guillermo Escudé argued that the currency board remains the cornerstone of Argentina’s nominal exchange rate stability, and abandoning it could have serious consequences because of large currency mismatches and high dollarization in the economy.

Hong Kong adopted a currency board as a response, not to hyperinflation, but to a confidence crisis and high market volatility in the early 1980s. Also, the underlying economic conditions there are significantly different from those in Argentina, which is probably why Hong Kong had a quick turnaround after the Asian crisis. Furthermore, the high foreign exchange coverage of the monetary base implies that the Hong Kong Monetary Authority can effectively act as a lender of last resort, thus reducing the risk of a systemic liquidity crisis. Having a lender of last resort does not detract from having strong and sound financial institutions. Priscilla Chiu documented that Hong Kong banks maintain capital and liquidity ratios of 18 and 40 percent, respectively, well above the recommended standards of 8 and 25 percent.

In the final country presentation, Peter Lohmus argued that, although inflation in Estonia in the early 1990s was still high, the decision to adopt a currency board was mainly political. After independence, the country needed to quickly implement reforms, but many of the institutions needed to effectively operate a more discretionary policy were missing. The currency board, along with sound macroeconomic policies, has sheltered Estonia from external shocks.

Proceedings of IMF conferences and seminars, including agenda and papers, can be obtained through the “Conferences, Seminars, and Workshops” link at http://www.imf.org/external/np/exr/seminars/index.htm.