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New Challenges for Exchange Rate PolicyRemarks by Horst Köhler
Managing Director of the International Monetary Fund
at the Asia-Europe (ASEM) Meeting of Finance Ministers
Kobe, January 13, 2001
1. Ladies and gentlemen, I am delighted to have the opportunity to participate in this meeting of Asian and European Finance Ministers. Today I would like to share my perspectives on the challenges that a globalized financial system poses for economic policy management--and especially, for exchange rate policy.
2. In today's global economy, weaknesses in economic policies and institutions are punished more swiftly and severely by markets than in the past. And, as conditions change, long-standing sources of vulnerability may suddenly become the focus of a financial crisis. While fluctuations and corrections are a normal part of the functioning of markets, we do need to find ways to make the international financial system less crisis-prone. The IMF has a unique and central role to play in this process--in the words of its Articles of Agreement--as a permanent mechanism for cooperation among its worldwide membership to ensure the effective operation of the international monetary system.
3. An intensive effort has gotten underway over the past three years to strengthen the international financial architecture. As part of that effort, the IMF is enhancing--as a matter of priority--its surveillance process to improve capabilities for crisis prevention and management. This process draws on increased transparency, better data systems, standards and codes, constructive engagement of the private sector, and the Financial Sector Assessment Program (FSAP), a joint initiative of the IMF and World Bank.
4. I am convinced that these reforms have made the international financial system stronger. But much more remains to be done. The IMF must gain a better understanding of the dynamics of international capital markets and the operations of private financial institutions, to fulfill more effectively its mandate to oversee the functioning of the international monetary system and promote international financial stability. Equally important, our member countries have a responsibility to do their part, by participating in these architecture initiatives and implementing structural reforms to increase the flexibility of their economies and eliminate sources of vulnerability. In particular, domestic financial sectors in many countries are not yet as robust as they need to be--and there is a risk that fading memories of the crises that began three years ago will undermine the support for further reform. The recent developments in Turkey are a powerful reminder of just how important it is to press forward in building strong financial sectors and supervisory frameworks. In order to make best use of the productive capacities of capital markets, financial and corporate sector reforms should get more, and not less, attention in the policy agenda.
5. Mr. Chino and Mr. Noyer have provided thought-provoking descriptions of the present situation. It is clear that the strong world economic expansion of the past two years is losing momentum, due in large part to the effects of last summer's runup in oil prices and developments in the advanced industrial countries. In particular, the slowdown in the United States and the stalling recovery in Japan have increased the downside risks in the global economy. But in our analysis, it would be an exaggeration to embark on doomsday scenarios now. The recent reduction in key US interest rates was a timely measure to help ensure a soft landing in the US and strengthen global growth prospects. If necessary, the US has further room to maneuver on both monetary and fiscal policy. In Europe, the fundamentals have improved and tax reforms are taking effect at the right time. But both Europe and Japan can and should do more to promote sustained growth and thereby strengthen investor confidence in the global economy. The key for this lies in a deepening and acceleration of structural reforms--with special attention to corporate and financial sector restructuring in Japan, and to labor market and pension reform in Europe. Moreover, the broader international community would and should boost investor confidence, not least in the Asia region, by embarking on new round on WTO negotiations designed to enhance free trade.
6. Let me turn now to the always-central issue of exchange rate regimes and exchange rate policy. Ever since the breakdown of the Bretton Woods system of fixed parities in the early 1970's, there has been widespread interest in exploring the scope for achieving greater stability in the exchange rates of the three major currencies. In particular, since the introduction of the euro, there has also been renewed attention to proposals for the possible adoption of exchange rate target zones. While most of us, faced with an unconstrained choice, would opt for arrangements that promise greater exchange rate stability, I think we must also recognize that the global environment is even less hospitable to such a system today than it was 25 years ago. Realistically, there is no alternative to floating exchange rates among the three major currencies.
7. However, this does not mean that the major industrial countries should practice benign neglect. The undervaluation of the euro (and corresponding overvaluation of the US dollar) may have boosted European exports, but it has also posed problems--not least for emerging market countries of Asia and Latin America. The good news is that a reversal has been getting underway, thanks mainly to better economic performance in Europe and slowing growth in the United States. It was right for the European Central Bank to make clear that a heavily undervalued euro was unacceptable. Its interventions have demonstrated the ECB's institutional maturity. Markets have taken note of this. But we also know that intervention cannot change market trends. Thus, intervention must be very selective and, ultimately, also well coordinated. Although it would be unwise to enter into formal commitments about particular exchange rate levels or ranges, the IMF's largest member countries do have a responsibility to make the most of possibilities for effective policy coordination to reduce exchange rate volatility and risk of misalignments.
8. Looking beyond the three major currencies, an important conclusion of our research and reviews of country experience in the IMF is that no single exchange rate regime is appropriate for all members in all circumstances. But that does not mean that the Fund has no advice to offer. A great deal can be said about the exchange rate regimes and associated policy frameworks that are relevant for particular members in specific circumstances.
9. In the wake of the Asian crisis, many emerging market countries have adopted systems of managed floating. And a number of countries still maintain fixed exchange rates. Experience has shown that heavily managed or pegged exchange rate regimes can be tested suddenly by exchange markets, and that it can be very costly either to defend them or to exit under disorderly circumstances. On balance, we have a responsibility to advise our members that while such regimes can succeed, the requirements for a country to maintain a pegged or heavily managed exchange rate are daunting--especially when the country is strongly engaged with international capital markets. There is essentially no room for error. Countries opting for such a system must pursue, unwaveringly, sound macroeconomic policies, and also need to be fully aware of the associated costs, including the possibility that extraordinarily high interest rates might be required at times of severe financial market pressure. Moreover, their domestic financial institutions and businesses must be well prepared to live with such policy adjustments. Where there is doubt that these requirements will be met, a flexible exchange rate regime--one in which the rate moves both up and down in response to market forces, sometimes by significant amounts--is a better choice.
10. Recently the international debate on the exchange rate policy options for emerging market and developing countries has focused on the desirability of "corner solutions"--either a more cleanly floating exchange rate or a hard peg. On balance, a floating rate system is more forgiving of policy errors, and therefore a somewhat safer solution for most countries. By this I do not mean a system in which the authorities are indifferent to the behavior of the exchange rate; indeed, it may at times be appropriate to adjust monetary policy in response to external developments. But with a floating rate, there is no need to risk unsustainable drains on its foreign exchange reserves to defend an exchange rate target. Moreover, a country can pursue a more independent monetary policy, while receiving important signals from the exchange markets about the soundness of its policy framework. To be sure, floating is no panacea. It requires an alternative anchor for monetary policy and inflation expectations, such as inflation targeting. And countries can still face difficult choices--especially if they are faced with large swings in international capital flows. Still, the absence of an exchange rate target provides an important, extra degree of freedom for domestic policy management and dealing with external shocks.
11. A country that is willing to abandon all monetary policy discretion may find it feasible to adopt a hard peg--either through a currency board arrangement or the use of another country's currency. Argentina, Bulgaria, Estonia and Lithuania each escaped from a cycle of chronically high inflation through strategies based on the use of currency boards. Hong Kong has maintained a currency board for nearly two decades. This type of commitment can provide greater credibility than managed floating or an adjustable peg. However, like those regimes, living safely under a hard peg obliges a country to have particularly sound financial and corporate sectors and strong support from macroeconomic policies, as well as considerable wage and price flexibility. On balance, hard pegs are appropriate only in limited circumstances--mainly for countries with a history of high inflation, that have the determination to implement very disciplined macroeconomic policies and ambitious structural reforms, but no other credible nominal anchor.
12. To sum up, my conclusion is that the IMF needs to support its member countries in making choices that best suit their needs, given the shocks they face and the stage of institutional development. For a wide range of countries, a floating exchange rate regime will be the best option. But no matter what type of exchange rate system a country may choose, ultimately it is the strength of the underlying policies and institutions that is decisive for sustained growth and financial stability.
13. Global capital markets are an indispensable source of financing for productive investment. But they are also a source of volatility and risk. We should not be surprised that the recent financial crises in emerging markets have led to renewed examination of the merits of capital controls. The earlier experience in Chile, for instance, confirmed that judicious use of controls on short-term inflows can help to avoid an excessive buildup of short-term debt. In the case of Malaysia, which adopted controls on capital outflows in the context of the Asian financial crisis, the evidence is not clear. In some other countries, the effect of capital controls has been clearly negative. In particular, when controls are used as a substitute for necessary adjustment or institutional development, they reduce a country's growth potential, create incentives for corruption and evasion, and impede access to foreign capital without addressing the underlying economic vulnerabilities. For this reason, even controls on short-term inflows should be used in support of sound policies, and in conjunction with an exit strategy and timetable for their removal. Given the mixed experience to date, I do see a need for further research and analysis, to help assess the costs and benefits of capital controls in particular circumstances. Still, there should be no confusion: in my view, integration into the global economy is challenging, but, over the long run, it clearly provides better prospects for growth and prosperity.
14. In particular, the benefits of carefully prepared integration into the global financial system outweigh the risks. But we should also draw a lesson from the recent crises in emerging markets that in some cases, there was clearly overly-rapid capital account liberalization. Coping safely with volatile international capital flows requires sound domestic financial systems, adequate supervision and prudential regulation, and good risk management capacities in banks and businesses, reinforced by greater transparency and market discipline. It is important to put these preconditions in place, insofar as possible, before the capital account is fully opened. Thus, in some cases, the transition may need to be gradual. To help our membership in this process, the IMF must stand ready to provide practical advice and technical assistance on the proper sequencing of financial sector development and capital account liberalization. At my request, the IMF staff will be reviewing the experience in a number of country cases in the coming months, in order to begin distilling more detailed, practical suggestions on sequencing.
My advice for countries that have already opened their capital accounts is to look forward, not backward. This means to concentrate on building a sound institutional and legal framework and strengthening investor confidence, so as to attract not only capital but also the knowledge and expertise to take advantage of the potential of international capital markets.
15. Regional cooperation and integration can play a very significant role in helping countries to become successfully integrated into the global trade and financial systems. Regional cooperation in Asia has recently gained new momentum, as a way to cope with the challenges of globalization. I find this quite natural and positive. Through the Chiang Mai initiative, the ASEAN+3 countries have proposed to strengthen regional financial cooperation through an expanded network of swap facilities. I welcome this initiative and encourage the ASEAN+3 countries to make it operative. I understand it as a complement to the IMF's financial assistance for members in the region which undertake adjustment efforts, and look forward to defining the modalities for our cooperation on this important matter.
16. Throughout much of my career, I was heavily involved in the process of European economic and monetary integration. The European Union represents a very far-reaching process of regional integration. At the outset, it was guided by strong political considerations--especially by the desire to promote peace and stability in a region devastated by the Second World War. In spite of the many difficulties it has faced in the past and the imperfections and tensions that are still evident today, European integration has clearly been a success story so far. This includes, not least, the introduction of a common currency and the conduct of a single monetary policy through the European Central Bank and the national central banks of the eurosystem. Getting to this stage has, however, required 50 years, building on rather modest beginnings in a Coal and Steel Community and expanding successively to a free trade zone, to a single market with a policy of harmonizing major regulations, and since January 1999 to a monetary union with a single currency.
17. There can be no doubt that this process of economic and monetary integration has helped to create wealth and stability in Europe. But the turbulences in the European Exchange Rate Mechanism in 1992 and 1993--which led the United Kingdom to leave the system and made it necessary to widen the exchange rate band of this system of fixed but adjustable exchange rates--served as a powerful reminder that a process of progressive monetary integration needs to build on strong convergence of national economic policies and performance. Furthermore, personally, I am still a believer that monetary union in Europe has to be underpinned, in the long run, by some form of political union--where the members are prepared to act together on a wider range of policies. The process of integration in Europe obviously has not yet ended, and its final outcome is still to be determined. In this context, the recent European Summit in Nice was another step forward. But it also highlighted the need to clarify further the nature of European integration.
18. I am not here to suggest that the European experience is a model that Asia can and should copy. Regional developments in Asia should be driven by its own political dynamics and unique historical background. But trading patterns and geography do make it reasonable to think of the creation of an internal market in Asia as a possible, future stage in regional cooperation. And why should this not be a basis for greater monetary integration, if that is what the people of Asia desire?
19. In closing, I would like to applaud and encourage the Asia-Europe Meetings, as a process to strengthen beneficial regional and inter-regional cooperation. I am honored that you have invited the IMF to participate in this meeting, and can assure you of our active interest in your future activities.
IMF EXTERNAL RELATIONS DEPARTMENT