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Exchange Rate Regimes in an Increasingly Integrated World Economy

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Exchange Rate Regimes in an Increasingly Integrated World Economy
By IMF Staff

June 2000

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This brief considers the choice of an appropriate exchange rate regime—floating, managed or fixed arrangements—for individual countries in light of important changes that have taken place in the world economy in recent years. These changes include the general increase in capital mobility and the abrupt reversals of capital flows to developing and transition economies. It is based on a recent IMF study, prepared by Michael Mussa, Paul Masson, Alexander Swoboda, Esteban Jadresic, Paolo Mauro, and Andrew Berg, which is now available in the IMF Occasional Paper series. The main conclusion is that it remains true that there is no single exchange rate regime that is best for all countries in all circumstances. Member countries continue to have scope to choose the type of exchange rate regime that best suits their needs, always with the proviso that the chosen regime must be credibly supported by policies consistent with the choice. Which exchange rate regime and associated policies are appropriate for a country depend on its particular circumstances. While increased capital mobility has been leading an increasing number of countries to either end of the spectrum between firmly fixed rates (or monetary unification) and free floating, intermediate regimes are likely to remain viable and appropriate in many cases.

I. Overview
II. Exchange Rate Regimes for Major Currencies
III. Exchange Rate Regimes of Medium-Sized Industrial Countries
IV. Exchange Rate Arrangements of Developing and Transition Countries
Figures   I.  Selected Industrial Economies: Bilateral and Effective Exchange Rates, 1997/1–1998/4
   II.   Developing Countries: Evolution of Pegged Exchange Rate Regimes1, 1975–1998

I.  Overview

The exchange rate regimes adopted by countries in today's international monetary and financial system, and the system itself, are profoundly different from those envisaged at the 1944 meeting at Bretton Woods establishing the IMF and the World Bank. In the Bretton Woods system:

  • exchange rates were fixed but adjustable. This system aimed both to avoid the undue volatility thought to characterize floating exchange rates and to prevent competitive depreciations, while permitting enough flexibility to adjust to fundamental disequilibrium under international supervision;

  • private capital flows were expected to play only a limited role in financing payments imbalances, and widespread use of controls would prevent instability in such flows;

  • temporary official financing of payments imbalances, mainly through the IMF, would smooth the adjustment process and avoid unduly sharp correction of current account imbalances, with their repercussions on trade flows, output, and employment.

In the current system, exchange rates among the major currencies (principally the U.S. dollar, the euro, and Japanese yen) fluctuate in response to market forces, with short-run volatility and occasional large medium-run swings (Figure 1). Some medium-sized industrial countries also have market-determined floating rate regimes, while others have adopted harder pegs, including some European countries outside the euro area. Developing and transition economies have a wide variety of exchange rate arrangements, with a tendency for many but by no means all countries to move toward increased exchange rate flexibility (Figure 2).

This variety of exchange rate regimes exists in an environment with the following characteristics:

  • partly for efficiency reasons, and also because of the limited effectiveness of capital controls, industrial countries have generally abandoned such controls and emerging market economies have gradually moved away from them. The growth of international capital flows and globalization of financial markets has also been spurred by the revolution in telecommunications and information technology, which has dramatically lowered transaction costs in financial markets and further promoted the liberalization and deregulation of international financial transactions;

  • international private capital flows finance substantial current account imbalances, but the changes in these flows appear also sometimes to be a cause of macroeconomic disturbances or an important channel through which they are transmitted to the international system;

  • developing and transition countries have been increasingly drawn into the integrating world economy, in terms of both their trade in goods and services and of financial transactions.

Lessons from the recent crises in emerging markets are that for such countries with important linkages to global capital markets, the requirements for sustaining pegged exchange rate regimes have become more demanding as a result of the increased mobility of capital. Therefore, regimes that allow substantial exchange rate flexibility are probably desirable unless the exchange rate is firmly fixed through a currency board, unification with another currency, or the adoption of another currency as the domestic currency (dollarization).

Flexible exchange rates among the major industrial country currencies seem likely to remain a key feature of the system. The launch of the euro in January 1999 marked a new phase in the evolution of the system, but the European Central Bank has a clear mandate to focus monetary policy on the domestic objective of price stability rather than on the exchange rate. Many medium-sized industrial countries, and developing and transition economies, in an environment of increasing capital market integration, may also continue to maintain market-determined floating rates, although more countries could may adopt harder pegs over the longer term. Thus, prospects are that:

  • exchange rates among the euro, the yen, and the dollar are likely to continue to exhibit volatility, and schemes to reduce volatility are neither likely to be adopted, nor to be desirable as they prevent monetary policy from being devoted consistently to domestic stabilization objectives;

  • several of the transition countries of central and eastern Europe, especially those preparing for membership in the European Union, are likely to seek to establish over time the policy disciplines and institutional structures required to make possible the eventual adoption of the euro.

The approach taken by the IMF continues to be to advise member countries on the implications of adopting different exchange rate regimes, to consider the choice of regime to be a matter for each country to decide and to provide policy advice that is consistent with the maintenance of the chosen regime (Box 1).

II.  Exchange Rate Regimes for Major Currencies

Over the past two decades, exchange rates among the major currencies—the U.S. dollar, the Japanese yen, and the deutsche mark with its partner currencies in the exchange rate mechanism of the European Monetary System, before the introduction of the euro in January 1999—and the currencies of other large industrial countries currencies have exhibited substantial short-term volatility, in nominal as well as real terms and also significant medium-term misalignments:

  • volatility has been considerably higher than it was under the Bretton Woods system prevailing from 1945 to 1971;

  • medium-term swings have been quite large, including the 1980–85 appreciation of the dollar and the 1990–95 appreciation of the yen, and their subsequent depreciations;

  • these wide swings in exchange rates have entailed misalignments relative to economic fundamentals, giving rise to questions of whether and how they can be avoided, or at least moderated.

Views on whether, how, and to what extent it might be desirable to attempt to stabilize the exchange rates of major industrial countries differ widely. They range from advocacy of pure floating, a view espoused especially by those who believe that exchange rates always reflect fundamentals and that governments and central banks do not possess knowledge superior to that of the market in such matters, to proposals for the introduction of a single world currency. Intermediate proposals include target zones, a quasi-fixed exchange rate regime among the major currencies to be achieved by monetary policy rules aimed at the exchange rate, and various schemes for policy coordination that would take the exchange rate into account.

There are two basic objections under current circumstances to any scheme that would attempt to achieve substantial fixity of exchange rates among the euro, yen, and dollar:

  • the first is that it would require largely devoting monetary policy to the requirements of exchange rate stability, which is likely to conflict with domestic objectives, including the objective of reasonable price stability. Indeed, the fact that movements of exchange rates among the major currencies have, on many occasions, reflected divergences in cyclical positions among the countries concerned and in the stances of monetary policy needed to achieve price stability and to support growth indicates that this concern is warranted;

  • second, the three major-currency areas do not conform to the usual criteria for an optimum currency area. The past decade has highlighted their lack of synchronization in economic activity and there is no reason to believe that differences across them would not continue to prevail in the future. In the absence of the type of political commitment that accompanied the euro's introduction, any attempt at fixing the exchange rates of the triplet could lack credibility and be rapidly undone by the market.

Nevertheless, a case can be made for monitoring potential major misalignments within the IMF's surveillance process and for occasional corrective measures.

III.  Exchange Rate Regimes of Medium-Sized Industrial Countries

Pegged exchange rate regimes have been extensively used over the past quarter century by medium-sized industrial countries, most notably in the exchange rate mechanism (ERM) of the European Monetary System. The presence of some residual restrictions on international capital movements, as well as the willingness to make parity adjustments before disequilibria became too large, contributed to the relatively smooth functioning of the ERM system in the 1980s. Subsequently, however, the system became subject to the major "asymmetric shocks" associated with German unification, and became more vulnerable owing to increasing capital mobility and the hardening of exchange rate parities following the negotiation of the 1991 Maastricht Treaty on political and monetary union. The system came under severe strain during 1992–93, when speculative pressures led to the withdrawal of Italy and the United Kingdom. The ERM then operated relatively smoothly during the years leading to the advent of the euro and the formation of European Monetary Union in 1999, which removed the risk of exchange rate crises within Europe and vindicated efforts to achieve convergence.

A number of other medium-sized industrial countries have successfully maintained floating exchange rate regimes over long periods, accepting that rates will move regularly and sometimes quite substantially in response to market forces. These countries include Canada which initially adopted a floating regime during 1952–60, and returned to floating in 1970, before the general collapse of the Bretton Woods system; Switzerland; and Australia and New Zealand, which have diversified trade partners as well as dependence on commodity exports. In the absence of an exchange rate peg, these countries have needed to establish an alternative nominal anchor for their monetary policies through a credible commitment to low inflation, which has in some cases been facilitated by an inflation target and operational independence for the central bank.

IV.  Exchange Rate Arrangements of Developing and Transition Countries

There is considerable diversity in the exchange rate regimes of developing and transition countries, from very hard currency pegs to relatively free floats and with many variations in between. This is not surprising in view of the wide differences among these countries in economic and financial circumstances. However, as these countries have adapted to expanding opportunities arising from deeper involvement in an increasingly integrated global economy and to changes in their own economic situations, there has been a shift toward greater flexibility, for the following reasons:

  • gross capital flows to developing countries have risen considerably since the early 1980s, increasing the potential for large and sudden reversals in net flows that would make pegged rates more difficult to maintain;

  • consistent with the trend toward globalization, many developing economies now trade with a wider range of partner countries. Countries with single-currency pegs are exposed to the wide fluctuations among major currencies.

Recent crises involving emerging market economies—from the "tequila crisis" of 1994–95 that originated in Mexico through the Asian/Russian/Brazilian crises of 1997–99—have led some observers to conclude that pegged exchange rate regimes are inherently crisis-prone, and that emerging market countries should be encouraged, in the interests of themselves and the international community, to adopt floating rate regimes. In considering this conclusion, it is important to stress a critical caveat: while recent crises have directly and adversely affected many emerging market economies linked to global financial markets, they have only indirectly affected (through movements in world commodity prices and trade flows) the majority of developing and transition countries. And factors other than the relative fixity of their exchange rate regimes were, of course, at the root of the problems of the most affected countries. In particular, Russia and Brazil had serious fiscal problems, while Asian crisis countries had weak financial and corporate sectors.

The following conditions are likely to favor the adoption by a country of some form of pegged exchange rate regime:

  • its degree of involvement with international capital markets is low;

  • its share of trade with the country to whose currency a peg is being considered is high;

  • the economic shocks it faces are similar to those facing the country to whose currency a peg is being considered;

  • it is willing to give up monetary independence for its partner's monetary credibility;

  • its economy and financial system already extensively rely on its partner's currency;

  • because of high inherited inflation, exchange-rate-based stabilization is attractive;

  • fiscal policy is flexible and sustainable;

  • labor markets are flexible;

  • it has high international reserves.

When these criteria are applied, one group of countries for which pegged exchange rates would seem to remain sensible are small economies with a dominant trading partner that pursues a reasonably stable monetary policy, including small Caribbean and Pacific island economies, and the CFA franc zone countries. For such countries, there is generally little point in incurring the costs of attempting to run an independent monetary policy.

Some important regional groups of emerging market economies—including the ASEAN and Mercosur countries—are in the situation of having both diversified linkages to the industrial countries and significant intraregional trade. These groups face the problem that substantial exchange rate fluctuations within the group, as well as vis-à-vis the industrial countries, can have destabilizing effects. One option to address this problem is to consider some form of regional monetary and exchange rate arrangement. However, neither of these groups presently has the institutional structures or the political consensus needed for regional economic integration, including for monetary and exchange rate policies, of the kind that took many years to develop in Europe. For the nearer term, less formal mechanisms for coordinating exchange rate policies may be feasible. Prior to the recent crisis, exchange rate policies among ASEAN countries were coordinated de facto by national policies that limited exchange rate fluctuations vis-à-vis the U.S. dollar. Similarly, in Mercosur, before the floating of the Brazilian real in early 1999, its fluctuations against the Argentine peso were limited by their respective policies concerning exchange rates vis-à-vis the U.S. dollar.

Pegged exchange rate regimes imply an explicit or implicit commitment by the policy authorities to limit the extent of fluctuation of the exchange rate to a degree that provides a meaningful nominal anchor for private expectations about the behavior of the exchange rate and the requisite supporting monetary policy. The hardest form of a pegged exchange rate regime is a currency board, under which monetary policy is entirely subordinated to the exchange rate regime (Box 2). Such an arrangement leaves no room for adjustments in the real exchange rate through changes in the nominal exchange rate. Accordingly, adjustments to changing conditions must be made by other means, including through domestic prices and costs, and economic activity and employment.

Under all exchange rate regimes other than absolutely free floating, ancillary policy to affect the foreign exchange market through official intervention and controls merits attention. The key point is that benign neglect of the exchange rate is unlikely to be desirable. When the foreign exchange market is thin and dominated by a relatively small number of agents, it is likely that the exchange rate will be volatile if the authorities do not provide some guidance and support. This problem is compounded if there is no long track record of stable macroeconomic policies that can firmly anchor market expectations. Thus in practice, even developing and transition countries that maintain relatively flexible exchange rate regimes typically use both monetary policy and official intervention to influence the exchange rate. Intervention is generally more effective in countries where access to international capital markets is limited so that the authorities have greater capacity to influence conditions in the foreign exchange market by directly buying or selling foreign exchange.


Box 1. IMF Advice on Exchange Rate Policy

In recent years, some observers have criticized the IMF for unduly favoring fixed exchange rates, others because it has appeared to show an inordinate fondness for currency devaluation, and yet others because it has appeared to have no principles guiding its advice on exchange rate regimes.

The usual approach taken by the IMF is to advise member countries on the implications of adopting different exchange rate regimes, to consider the choice of regime to be a matter for each member country, and to tailor its overall policy advice to the regime chosen in each case. Discussions about the appropriate exchange rate policy and regime, and, issues relating to exchange restrictions may be important and, at times, central aspects of program negotiations and surveillance discussions. But given a country's chosen exchange rate regime, the approach followed by the IMF is to provide policy advice that is consistent with the maintenance of the chosen regime and other policy objectives.

Accepting a country's preferred exchange rate regime does not prevent the IMF from offering the authorities an assessment of whether the prevailing exchange rate regime is broadly consistent with the country's external and domestic policy goals, nor from recommending policy changes that may be required in order to ensure such consistency. In fact, since providing this type of advice is at the core of IMF responsibilities, attention is paid to the sustainability of the exchange rate policy followed in countries where the authorities are committed to defend a particular path for the exchange rate, as well as to the possibility of misalignments of the exchange rate in countries that let the exchange rate float.

For these purposes, the IMF routinely examines a wide range of economic indicators for each member country and analyzes them in the light of the country's structural characteristics, the international context, and accumulated knowledge on exchange rate issues. In recent years, in addition to traditional domestic and external sector indicators—such as the fiscal deficit, monetary or domestic credit growth, the real exchange rate, international reserves and the current account—increasing attention has been paid to indicators for the financial sector and the capital account.

In the case of IMF-supported programs, the Fund lends to a country defending a peg or some other type of exchange rate commitment only if its assessment is that such a policy is sustainable, under the programs, although there have been cases in which pegs subsequently had to be abandoned, typically in the context of policy slippages.


Box 2. Currency Boards

Currency board arrangements are the strongest form of exchange rate peg, short of a currency union or outright dollarization. A currency board is committed to supplying or redeeming its monetary liabilities at a fixed exchange rate, which implies that it must hold foreign reserves at least equal to its total monetary liabilities. Moreover, these are the only terms under which a currency board can exchange monetary liabilities; that is, in its pure form, a currency board cannot extend credit. Under these conditions, even short-term interest rates become completely independent of the will of the domestic monetary authorities: market arbitrage will imply that interest rates are closely linked to those of the anchor currency.

The key conditions for the successful operation of a currency board, in addition to the usual conditions deemed desirable for a fixed exchange rate regime, are a sound banking system, because the monetary authorities cannot extend credit to banks experiencing difficulties; and a prudent fiscal policy, owing to the prohibition of central bank lending to the government.

The advantages of such a system include the credibility of the economic policy regime. Such credibility results from the high political cost of altering the exchange rate. In the past, boards have often been adopted by small open economies wishing to curb inflation; experience has shown that they can facilitate disinflation in larger economies as well.

The costs of such a system include the absence of central bank monetary operations to smooth out very short-term interest rate volatility and the absence of a lender of last resort. Indeed, countries with this arrangement have experienced banking collapses, leading some of them to establish limited lender-of-last-resort facilities. Finally, the absence of domestic credit by the central bank implies that seigniorage is lower than under a normal peg.

The main differences between a currency board and outright dollarization are that in the former case the country retains its national currency and hence seigniorage, whereas in the latter case seigniorage goes to the country of the anchor currency unless special arrangements are made; and that dollarization represents an even more complete renouncement of sovereignty.