## _op256 ## Source details **Canonical URL:** [_op256](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/op/256/_op256.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/op/256/_op256.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/op/256/_op256.pdf.json) --- ### Overview - Many countries moved toward more flexible exchange rate regimes over the past decade. - Expected benefits of more flexible exchange rates: - Provide a greater degree of monetary policy autonomy and flexibility in responding to external shocks, including large and volatile capital flows. - (1) Reduce one-way bets against currencies, thereby discouraging short-term capital inflows that can be easily reversed. - (2) Discourage a buildup of large unhedged foreign currency positions by reducing the implicit exchange rate guarantees implied by pegged and tightly managed exchange rates. - (3) Stimulate prudent risk management and foreign exchange (FX) market development as market participants seek to hedge against potentially greater exchange rate risks. - Factors causing reluctance to abandon pegs (the “fear of floating”): - (1) Concerns about losing policy credibility. - (2) Adverse effects of a potential appreciation of the domestic currency on external balances. - (3) Higher inflation from exchange rate pass-through (given limited technical and institutional capacity to implement alternative monetary policy frameworks such as inflation targeting (IT), and underdeveloped financial markets characterized by larger exchange rate fluctuations). - (4) Potential losses from currency mismatches, in particular when markets and instruments to hedge against risks are limited. - Countries that mitigate risks associated with floating can achieve smoother exits even when supporting elements are not fully in place before the move. ### Fixed-to-Float Framework (summary) - Four generally needed “ingredients” for a successful transition: - (1) Developing a deep and liquid FX market. - (2) Setting up adequate systems to review and manage exchange rate risks. - (3) Formulating coherent intervention policies consistent with the new regime. - (4) Establishing an appropriate alternative nominal anchor in the context of the new monetary policy framework. - Framework draws on Duttagupta, Fernandez, and Karacadag, 2004, and was endorsed by the IMF Executive Board in December 2004. ### Addressing the “Fear of Floating” — Measures - For policy credibility concerns: - Stronger monetary policy framework with a transparent, alternative monetary anchor. - Operational independence of the central bank. - Prudent monetary and fiscal policies. - Deep FX markets and appropriate intervention policies. - For fear of inflation: - Strong monetary policy framework as above. - For fear of appreciation and adverse external balance impact: - Fiscal retrenchment. - Structural reforms to improve external competitiveness. - For fear of exchange rate losses from currency mismatches: - Strong financial sector policies with adequate prudential and supervisory systems for FX risk management. - Well-developed FX and money markets to hedge risks. ### Operational Ingredients: key aspects and sequencing - Deep and liquid FX markets: - Essential for price discovery and allowing the exchange rate to respond to market forces. - Development requires: eliminating market-inhibiting regulations; improving market microstructure; increasing information flows; reducing the central bank’s market-maker role. - Allowing some exchange rate flexibility helps create two-way risk necessary for risk management. - Private sector FX risk exposure and supervisory capacity: - Market participants need analytical and information systems to monitor and measure risks. - Adequate prudential and supervisory arrangements and enforcement capacity are needed to monitor banks’ direct and indirect FX exposures. - Developing derivatives markets for foreign exchange with appropriate safeguards is essential. - Role of macroeconomic and structural policies: - Sound macroeconomic and structural policies—including fiscal discipline, monetary policy credibility, and a sound financial sector—are essential to maintaining any type of regime, fixed or floating. ### Country experiences and practical lessons (selected) - Variation in timing and priority of operational elements depending on initial conditions; progress on the four ingredients generally contributed to smoother exits. - Two broad exit patterns: - Gradual, orderly exits (Chile, Israel, Poland). - Fast, disorderly exits under market pressure (Brazil, Czech Republic, Uruguay). - Examples of durations and sequencing: - Chile: about 15 years to transition to a full float. - Israel: about 20 years. - Poland: about 10 years. - Fast exits: Brazil (1999) — de facto crawling peg; Czech Republic (1996–97) — horizontal band; Uruguay (2002) — crawling band. - Final regimes observed among case studies: - Free float with explicit inflation targets: Brazil, Chile, Czech Republic, Israel, Poland. - Monetary targets: Uruguay (with a plan to adopt IT). ### Intervention strategy and principles (operational guidance) - Under a flexible exchange rate regime intervention is discretionary; well-specified intervention principles are essential. - Possible objectives of intervention include: - Correcting misalignments. - Calming disorderly markets. - Meeting reserve targets. - Supplying publicly acquired foreign exchange. - Key guidance: - Signal commitment to a market-determined rate and avoid excessive smoothing of short-term fluctuations. - Transparency of intervention policies is important for building confidence; public commitment to objectives and principles enables market scrutiny and accountability. ### Replacing the exchange rate with a credible nominal anchor - Move to flexibility requires replacing the exchange rate with an alternative credible nominal anchor and redesigning monetary policy. - Recent moves favored IT frameworks over money-targeting because of the weak relationship between monetary aggregates and inflation. - Preconditions for adopting IT: - Extensive preparation, substantial capacity building, credibility building, and planning ahead. ### Sequencing exchange rate flexibility with capital account liberalization - Trade-offs: - Risks of opening the capital account before a flexible exchange rate include forced exits after sudden reversals of capital flows or heavy inflows and appreciation pressures on pegs. - Benefits of liberalizing the capital account include offsetting transitory current account shocks, expanding risk-management instruments, and deepening the FX market. - Practical sequencing used: - Liberalize long-term inflows before short-term ones; liberalize outflows to reduce appreciation pressure from inflows. ### Systems to assess and manage FX risks (selected country evidence) - Chile: - About 90%–100% of bank exposures hedged; 40% of corporate exposures hedged. - Turnover in the FX derivatives market rose from 0.06 percent of GDP in 1993 to 1.4 percent of GDP in 1998, and to 2.9 percent by 2003. - Spread on a forward contract fell from 26 basis points to 16 basis points between 1998 and 2003. - Israel: - BoI nonintervention from mid-1997 made FX risks explicit, led to a fall in net FX liabilities, and stimulated hedging instrument growth. - Band formally abolished in June 2005; by then band width about 62.5 percent around a theoretical midpoint. - Poland: - Key dates and numeric milestones: - October 14, 1991: crawling peg with monthly rate of crawl: 1.8% and formal fluctuation band ±2.0% (NBP margin ±0.5%). - May 16, 1995: fluctuation band increased to ±7.0%. - February 26, 1998: monthly rate of crawl: 0.8%; fluctuation band increased to ±10.0%. - July 31, 1998: final abolition of direct interventions on the FX market. - April 12, 2000: formal introduction of the floating exchange rate regime. - Brazil: - Adopted IT rapidly after the float: intention declared February 1999; IT implemented within six months with targets set for 1999, 2000, and 2001. - Primary surplus rose by 3.3 percentage points of GDP during 1999 as part of fiscal tightening. ### FX intervention policies, transparency, and market development - Gradual exits: - Intramarginal interventions were gradually abandoned to enhance credibility; interventions became less frequent and more transparent. - Examples: Czech Republic abolished fixing at exit; Israel adopted formal no-intervention-within-the-band policy mid-1997. - Disorderly exits: - Authorities often intervened more actively during and after crisis exits to stabilize markets and rebuild credibility (Brazil, Uruguay). - Central bank roles in market development: - Reduced market-maker role over time; promoted derivatives; improved market infrastructure and benchmarks; sometimes issued instruments to kick-start derivatives markets. - Prudential trade-offs: - Restricting derivatives could push activity offshore (example: nondeliverable forwards market for the zloty in London). ### Challenges in transitioning to greater flexibility - Common challenges: - Assessing preparedness and timing for increased flexibility. - Restoring and maintaining monetary policy credibility and finding a new nominal anchor. - Determining the central bank’s market role during and after the move. - Calibrating transparency and communication. - Cases of weak preparedness: - Uruguay, Brazil, Czech Republic: exits under market pressure with many supporting elements absent required intensive capacity building post-exit. - Information issues: - Lack of reliable, prompt information on private sector balance sheets and exchange rate pass-through complicated timing decisions (Chile example: pass-through overestimated). ### Conclusions and Lessons from Country Experiences (numbered findings) - 1. Gradual transitions through increasingly flexible intermediate regimes offer time to prepare and reduce scope for policy reversals. - 2. Balance caution with the mutually reinforcing relationship between flexibility and capacity building; premature flexibility can be damaging, but over-waiting can increase risk of forced exits. - 3. Disorderly exits highlight premium markets place on consistent macroeconomic and financial policies under capital mobility; supportive fiscal policies reduced burden on monetary policy during transitions. - 4. Coordinating exit strategy with capital account liberalization may reduce pressure on macroeconomic policies and help avoid disorderly exits. - 5. Early deployment of the four building blocks greatly facilitates transition; building them takes time and capacity-building efforts. - 6. Transparent and effective communication strategy essential to prepare economies for greater flexibility and contribute to credibility. - 7. No unique sequencing; basic elements commonly put in place early: alternative monetary framework, FX markets, FX risk management systems; intervention policies often announced at exit. - 8. Introducing some exchange rate flexibility can spur market and institutional development; a virtuous cycle often emerges. - 9. Authorities played a crucial role: providing stable regulation and infrastructure; acting initially as market makers; issuing bills for monetary management; promoting hedging instruments; withdrawing market-maker role as markets matured. - 10. Relationship between flexibility and building blocks may be nonlinear: small degrees of flexibility can help build ingredients, but too much flexibility without building blocks is risky. - 11. In market-pressure exits, absent building blocks complicated transition and stabilization, especially in highly dollarized economies. - 12. Disorderly exits can be durable if lack of preconditions is quickly addressed through intensive capacity building (establishing IT, markets, risk management). - 13. Markets test authorities’ commitments; credibility is established when commitments withstand market tests. Consensus and coordination among key parties are important. ### Policy implications and operational recommendations - Early preparation and capacity building: - Build the four ingredients iteratively; develop interbank money and securities markets; strengthen FX risk management across banks and corporates. - Coordination of macroeconomic policies: - Ensure fiscal policy supports monetary policy; coordinate exit with capital account liberalization and remove asymmetries (for example, liberalize capital outflows when appropriate). - Market development and sequencing: - Introduce limited two-way exchange rate variation to stimulate FX activity; use central bank market-maker role temporarily and withdraw as markets mature; sequence derivatives liberalization cautiously with safeguards. - Communication and credibility: - Implement transparent communication strategies; secure consensus among key parties; maintain consistent policy mixes to withstand market tests. *Source: IMF staff paper summarized from the provided content of _op256.* ### 1. Foreign exchange administration — Case studies. 2. Foreign ### _op256 - 1. Foreign exchange administration — Case studies. 2. Foreign ### Overview - Many countries moved toward more flexible exchange rate regimes over the past decade. - Expected benefits of more flexible exchange rates: - Provide a greater degree of monetary policy autonomy and flexibility in responding to external shocks, including large and volatile capital flows. - (1) Reduce one-way bets against currencies, thereby discouraging short-term capital inflows that can be easily reversed. - (2) Discourage a buildup of large unhedged foreign currency positions by reducing the implicit exchange rate guarantees implied by pegged and tightly managed exchange rates. - (3) Stimulate prudent risk management and foreign exchange (FX) market development as market participants seek to hedge against potentially greater exchange rate risks. - Factors that cause reluctance to abandon pegs (the “fear of floating”): - (1) Concerns about losing policy credibility. - (2) Adverse effects of a potential appreciation of the domestic currency on external balances. - (3) Higher inflation from exchange rate pass-through (given limited technical and institutional capacity to implement alternative monetary policy frameworks such as inflation targeting (IT), and underdeveloped financial markets characterized by larger exchange rate fluctuations). - (4) Potential losses from currency mismatches, in particular when markets and instruments to hedge against risks are limited. - Countries that mitigate risks associated with floating can achieve smoother exits even when supporting elements are not fully in place before the move. ### Fixed-to-Float Framework (summary) - The IMF’s operational framework for moving toward exchange rate flexibility identifies four generally needed “ingredients” for a successful transition: - (1) Developing a deep and liquid FX market. - (2) Setting up adequate systems to review and manage exchange rate risks. - (3) Formulating coherent intervention policies consistent with the new regime. - (4) Establishing an appropriate alternative nominal anchor in the context of the new monetary policy framework. - The framework and guidance draw on Duttagupta, Fernandez, and Karacadag, 2004, and were endorsed by the IMF Executive Board in December 2004. ### Addressing the “Fear of Floating” - Measures that could mitigate factors that give rise to the fear of floating: - For policy credibility concerns: Stronger monetary policy framework with a transparent, alternative monetary anchor; operational independence of the central bank; prudent monetary and fiscal policies; reasonably well-developed, deep FX markets and appropriate intervention policies to reduce excessive exchange rate volatility. - For fear of inflation: Strong monetary policy framework as above. - For fear of appreciation and adverse external balance impact: Fiscal retrenchment; structural reforms that would improve external competitiveness. - For fear of exchange rate losses from currency mismatches: Strong financial sector policies with an adequate prudential and supervisory system for FX risk management; reasonably well-developed FX and money markets to hedge risks. ### Operational Ingredients: key aspects and sequencing - Deep and liquid FX markets: - Essential for price discovery and allowing the exchange rate to respond to market forces. - Help minimize disruptive day-to-day fluctuations and facilitate FX risk management. - Development requires: eliminating market-inhibiting regulations; improving market microstructure (for example, by allowing risk-hedging instruments, simplifying FX legislation, or putting in place adequate payment and settlement systems); increasing information flows; and reducing the central bank’s market-maker role. - Allowing some exchange rate flexibility helps create a two-way risk necessary for better risk management and limiting destabilizing trading strategies. - Private sector FX risk exposure and supervisory capacity: - Private sector FX exposures affect the pace and type of exit and intervention policies. - Market participants need analytical and information systems to monitor and measure risks, internal risk management, and prudential procedures. - Adequate prudential and supervisory arrangements and enforcement capacity are needed to monitor banks’ direct and indirect FX exposures and related risks. - Developing derivatives markets for foreign exchange with appropriate safeguards is essential to build capacity to manage FX risks while limiting potential misuse for speculative activity. - Role of macroeconomic and structural policies: - Sound macroeconomic and structural policies—including fiscal discipline, monetary policy credibility, and a sound financial sector—are essential to maintaining any type of regime, fixed or floating. ### Country experiences and practical lessons - Country case studies in the paper present concrete steps taken by selected countries in transitioning to greater exchange rate flexibility and elaborate on operational elements that promoted successful and durable transitions. - Experiences show variation in timing and priority of operational elements depending on initial conditions and economic structure; however, progress on the four ingredients generally contributed to smoother exits. - Countries that emphasized preparedness adopted cautious and gradual approaches while establishing necessary supportive elements; others experienced difficulty when exits occurred under market pressure with little preparation. *Source: IMF staff paper summarized from the provided content of _op256.* ### Box 1. Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates ### Box 1. Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates ### Overview - The box draws on case studies of six durable exits: Brazil, Czech Republic, Uruguay (exits under market pressure), and Chile, Israel, Poland (gradual and orderly transitions). - Appendices supplement with three short-lived exits (Ecuador, Pakistan, Uzbekistan) and one ongoing transition (Ukraine) to illustrate factors undermining durability and challenges in transition. - The analysis focuses on how operational ingredients for floating were established and coordinated with the exit, interaction with macro and other conditions, and contributions to smoothness and durability. ### Intervention strategy and principles - Transition to flexible exchange rates requires a coherent intervention strategy with specific policies on objectives of intervention. - Under a flexible exchange rate regime intervention strategy becomes discretionary; therefore, well-specified intervention principles are essential to enhance the credibility of the new regime. - Possible objectives of intervention include: - Correcting misalignments - Calming disorderly markets - Meeting reserve targets - Supplying publicly acquired foreign exchange - Key operational guidance: - Signal commitment to a market-determined rate and avoid excessive smoothing of short-term fluctuations. - Avoiding excessive smoothing is crucial to: - Not suppress nascent markets and useful market signals - Avoid sending confusing messages about policy intentions - Transparency of intervention policies is important for building confidence, especially after forced exits. - A public commitment to objectives and principles enables market scrutiny and accountability for FX operations. ### Replacing the exchange rate with a credible nominal anchor - Moving to flexibility requires replacing the exchange rate with another credible nominal anchor and redesigning the monetary policy framework around the new anchor. - A credible alternative anchor is essential to stabilize market expectations and maintain or regain credibility and monetary stability after exiting a peg or following a disorderly exit. - Recent moves favored IT frameworks over money-targeting because of the weak relationship between monetary aggregates and inflation. - Preconditions for adopting IT: - Extensive preparation - Substantial capacity building - Credibility building - Planning ahead for the transition is critical; a lengthy transition period often reflects time needed to fulfill institutional requirements and macroeconomic conditions. ### Pace of exit, sequencing, and trade-offs - Decisions on pace and sequencing (including capital account liberalization) involve trade-offs and country-specific considerations (degree of preparedness, openness of capital account, macroeconomic situation, domestic and international market conditions). - If taken from a position of macroeconomic strength, a faster exit can signal determination and enhance monetary policy credibility. - The speed of institutional development is often the main determinant of how fast an orderly exit can proceed. - Early preparation for float is essential; elements taking the longest to build (capacity to operate under an alternative framework and markets) should be prioritized. ### Sequencing exchange rate flexibility with capital account liberalization - Clear trade-offs exist: - Risks of opening the capital account before adopting a flexible exchange rate include forced exits after sudden reversals of capital flows or heavy inflows and appreciation pressures on pegs. - Benefits of liberalizing the capital account include: - Offsetting transitory current account shocks - Expanding instruments for risk management - Deepening the FX market (important for operating a flexible exchange rate) - Transition can be facilitated by removing or strengthening existing asymmetries in capital account openness to support orderly correction of misalignments (for example, by liberalizing outflows to reduce pressures from inflows and/or liberalizing long-term inflows before short-term ones). ### Nature and pace of the six exits - Three exits were gradual and orderly; three were fast and under market pressure. - Fast exits (within at most six months of market pressures): - Brazil (1999) — de facto crawling peg - Czech Republic (1996–97) — horizontal band - Uruguay (2002) — crawling band - Gradual exits: step-by-step moves to a full float through increasingly flexible pegs. - Final regimes: - Free float with explicit inflation targets: Brazil, Chile, Czech Republic, Israel, Poland - Monetary targets: Uruguay (with a plan to adopt IT) - In gradual exits, transition to full-fledged IT was gradual through an initial simultaneous pursuit of exchange rate and inflation targets; countries with disorderly exits (except Uruguay) adopted full-fledged IT faster. - Durability: All six exits were durable with no major reversals returning to pegs; some temporary reversals included: - Chile: temporarily reduced width of the crawling band in 1998 - Israel: re-intervened in 1996 in response to large capital inflows - Brazil: interventions in 2001–02 and 2005–06 to correct disorderly market conditions and to rebuild reserves, respectively ### Duration and sequencing details (selected cases) - Gradual exits were lengthy: - Chile: about 15 years to transition to a full float - Israel: about 20 years - Poland: about 10 years - Slow transitions reflected time needed to establish elements mitigating concerns about floating (loss of policy credibility, loss of competitiveness from potential appreciations, pass-through to inflation, balance sheet effects). - Gradual increases in exchange rate flexibility helped deepen FX markets and establish pillars of greater flexibility. - In involuntary exits, benefits of floating were generally not recognized beforehand; concerns included potential return of inflation, loss of competitiveness (Czech Republic), and currency mismatches in a largely dollarized banking system (Uruguay). - Fast disorderly exits lacked credibility benefits because they occurred without crucial institutional underpinnings; finding an alternative anchor in a crisis environment complicated stabilization efforts. ### Table 1 highlights (selected descriptive entries) - Brazil: Pace of the exit — Fast (1999); Crisis-driven (substantial); Joint decision between the government and the central bank; From de facto crawling peg to Free float; Duration of the exit — One week (failed attempt at introducing “endogenous diagonal band” lasted two days) - Chile: Pace of the exit — Gradual (1984–99); Mostly orderly; Joint decision; From Crawling peg (Sep. 1982) to crawling band to Free float (Sep. 1999); Duration — Crawling peg (about two years); increasingly wider crawling bands (15 years) - Czech Republic: Pace of the exit — Fast (1996–97); Crisis (small); No joint decision; From Horizontal band to Managed float; Duration — One month (the horizontal band was widened one year prior to the exit) - Israel: Pace of the exit — Gradual (1985–2005); Mostly orderly; No, unilateral decision; From Peg to horizontal band; De facto free float (June 2005); Duration — Crawling peg to crawling band (four years); crawling band to increasingly wider bands (two years) - Poland: Pace of the exit — Gradual (1990–2000); Joint decision; From Single currency peg to a basket; Free float (Apr. 2000) and formal free float (June 2005); Duration — Horizontal band to increasingly wider crawling bands (two years); crawl rate adjustments - Uruguay: Pace of the exit — Fast (2002); Crisis (substantial); Joint decision; From Crawling band to Free float, with monetary aggregate targets; Duration — Band width prior to the exit; crawling band to de facto float within an increasingly wider crawling fan (six years); de facto to formal free float (eight years) *Source: Detailed case studies in the referenced chapter.* ### Introduction of ### Introduction of ### The Nature and Pace of the Exits - Two broad exit patterns documented: gradual orderly exits and fast disorderly exits (Figures 2a and 2b). - Chart annotations and episode specifics included: - "Slope reduced to 1.8%" - "Bandwidth reduced to 3%" - "Free float" - "Slope increased to 2.4%" - "Bandwidth increased to 12%" - "Slope reduced to 0.6%" - "Slope inceased to 1.2%" - "Bandwidth increased to 6%" - Country examples shown with exchange-rate indices normalized to "1991 = 100" for some series (Brazil: Real/US$; Czech Republic: CZK/Basket; Uruguay: Peso/US$; plus Chile: Peso/US$, Israel: Shekel/Basket, Poland: Zloty/Basket). - Visual indicators in figures: "Exchange rate", "Indicative band lower (to deutsche mark)", "Indicative band upper (to deutsche mark)", "Lower basket corridor", "Upper basket corridor", "Upper band", "Lower band". ### Factors that Triggered the Move to Greater Flexibility - Primary motivations and triggers summarized across six case-study countries (Table 2: Brazil, Chile, Czech Republic, Israel, Poland, Uruguay). - Main incentives for gradual exits: - "A growing emphasis on reducing inflation as compared with other goals (for example, competitiveness) was the main incentive for the gradual exits." - Adoption of preannounced crawling pegs at initial stages to balance inflation reduction and competitiveness. - Capital account opening and inflows complicated monetary management: maintaining both inflation and exchange rate targets required large-scale sterilizations that became costly or counterproductive. - Flexible exchange rates helped absorb inflows and allowed setting interest rates consistent with inflation targets; reduced implicit exchange rate guarantees helped limit speculative inflows. - Forced exits triggered by contagion from international financial crises: - Russian crisis for Brazil; Asian crisis for the Czech Republic; Argentine crisis for Uruguay. - Contagion exposed domestic macroeconomic or financial vulnerabilities and policy inconsistencies, leading to downward pressure and regime collapse. - Tight domestic monetary policies had attracted significant short-term capital inflows, creating rising external deficits and overheating pressures that undermined peg sustainability (Brazil and Czech Republic). - In Uruguay, high dollarization of public and private sectors combined with external shocks amplified imbalances and undermined confidence, contributing to crawling band collapse. - Risk-management motives: - Example: Israel moved to a crawling fan regime in mid-1997 to increase perception of two-way FX risk by asymmetrically widening the weaker limit of the band, encouraging FX hedging tool development. - Greater flexibility can reinforce risk mitigation by encouraging market hedging and private sector adaptation. ### Coordination of Transitions with the Supporting Elements of a Floating Regime - Advance preparation and having "main ingredients of flexibility fully in place before the switch to a full float" contributed to orderly, durable transitions (Table 3). - Key lessons: - Agreement on transition principles and target regime characteristics provided a framework and helped moderate exit severity. - Introducing some flexibility allowed capacity building for floating, which in turn permitted more exchange rate flexibility. - Advance preparation reduced the likelihood of costly crisis exits and moderated exits under market pressure. - Reversals and delays highlighted operational weaknesses (Appendix II examples): - Underdeveloped and illiquid FX market (Uzbekistan). - Limited capacity to manage exchange rate risk (Ecuador, Uzbekistan, Pakistan). - Lack of appropriate intervention policy (Uzbekistan, Pakistan). - Limited institutional/technical capacity to adopt a credible nominal anchor (Uzbekistan, Pakistan). - Ukraine case underscores importance of quickly establishing necessary floating-regime ingredients to limit policy reversals (Appendix III). ### A Deep and Liquid FX Market - Common pattern in gradual exits: - FX market typically illiquid and often central-bank dominated initially; the central bank’s fixing mechanism was gradually reduced (fixing formally ended in Israel in 1990 and Poland in 1999). - Market development often accelerated only after introduction of some exchange rate flexibility: - Israel: when exchange rate allowed to vary within a ±5 percent band. - Chile: after widening of the band to ±5 percent. - Poland: after adoption of a crawling band with a ±7.0 percent width. - Czech Republic: market developed more rapidly after band widened from ±0.5 percent to ±7.5 percent. - Sequencing of market development: - Spot FX markets tended to develop first, followed by derivatives (forwards, swaps, options, futures). - Well-developed spot markets existed in all six countries at the time of exit; derivatives markets were less developed and emerged gradually. - Country specifics: - Uruguay: only the spot market was well developed before the float; derivatives markets were virtually nonexistent pre-float and promoted after the float in 2002. - Brazil and Chile: FX spot and derivatives markets developed steadily from the mid-1990s until the float in 1999. - Chile, Czech Republic, Israel, Poland: derivatives markets developed in tandem with greater exchange rate flexibility. - Central bank roles in market development: - Stimulated market development by (1) allowing some flexibility through widening trading bands; (2) reducing central bank market role (ceasing to be sole market maker, ending fixing interventions, discontinuing inner bands); (3) removing obstacles to market activity (permitting arbitrage, liberalizing bank-client markets, encouraging interbank trading). - Upgraded market infrastructure (e.g., sophisticated trading mechanisms and over-the-counter continuous trading in Israel). - Actively promoted derivatives markets and removed impediments to forwards, swaps, and other derivative transactions (Chile, Czech Republic, Poland). - Occasionally issued instruments to kick-start derivative markets (Bank of Israel) or participated in derivative transactions after float (Central Bank of Uruguay). - Complementary markets and prudential considerations: - Liquid short-term interbank money and government securities markets were closely linked to spot and derivatives FX markets by providing interest rate benchmarks needed for pricing swaps and forwards. - Such complementary markets were essential for Israel and Poland; their absence (Uruguay) hindered derivatives development until after the float when authorities moved to support domestic-currency bill markets. - Central banks also contributed by creating infrastructure, setting standards, benchmark reference rates, and incentives (example: National Bank of Poland). - Authorities recognized derivatives could facilitate speculation (examples: forward transactions implicated in speculative attacks in Israel; derivatives augmented appreciation pressure on the zloty in Poland). - Restricting derivatives could be counterproductive by driving activity offshore (example: nondeliverable forwards market for the zloty in London). *Source: Detailed case studies.* ### 1991. However, the ### _op256 - 1991. However, the ### Systems to assess and manage FX risks - Private sector capacity to manage FX risk was reasonable in most countries at the time of the float. - Explicit incorporation of indirect FX risks (for example, in capital or loan classification requirements) generally came only after the float, often as part of harmonization with European Union directives. - In Chile and Israel, FX risk management capacity development went hand in hand with explicit recognition, regulation, and reporting of banks’ FX exposures. - Gradual liberalization of swap and forward transactions throughout the transition process facilitated hedging. - Chile: currency mismatches in banking and corporate sectors were limited; about 90%–100% of bank and 40% of corporate exposures were hedged. - Israel: nonintervention policy of the BoI from mid-1997 made FX risks explicit, shifted responsibility to risk-takers, led to a fall in net FX liabilities, and stimulated growth of hedging instruments. - Brazil and Uruguay: room for improvement in FX risk management at exit. In Uruguay, supervisory/regulatory environment had not specifically addressed rising FX risk in a highly dollarized economy; FX-related prudential rules tightened after a major bank restructuring following the float. - Brazil: no limits on global FX risk exposures of financial institutions in terms of capital at the time of exit, though direct restrictions affected FX activity; private sector unhedged exposure limited via natural hedging, issuance of dollar-indexed public debt, and derivatives. - Typical post-float regulatory responses included liquidity requirements on FX deposits, inclusion of FX risks in loan classification and provisioning, currency-specific capital requirements, stress testing, and reporting of FX risk management policies. ### Sequencing with inflation targeting (IT) - Gradual exits: adoption of full-fledged IT followed a lengthy transition—10 years in Chile and 8 years in Israel from the first annual inflation targets. - Poland: partial form of IT introduced relatively quickly; close to two years for full-fledged IT to be introduced with the float. - Fast exits: IT introduced after floats, requiring intensive capacity building. Brazil and the Czech Republic introduced IT after three and six months of preparation respectively. - Uruguay: step-wise approach—monetary targeting adopted in absence of many IT conditions; efforts accelerated to establish IT preconditions. - Adoption of IT without full preconditions caused credibility difficulties in some fast-exit cases (Brazil, Czech Republic), requiring tighter financial policies and heavy investment in forecasting and communication. - Lengthy transitions tended to leave most preconditions of full-fledged IT satisfied by the time of exit. ### Sequencing with capacity to implement monetary policy - Monetary operations capacity to affect short-term interest rates was generally well advanced at the time of the exit in most countries. - A clear policy rate existed or was being established at the time of the regime shift (Brazil, Israel, Poland; Chile and Czech Republic were in progress). - Interest rate corridor systems and other operational frameworks were put in place before or shortly after floats; full corridor implementation often followed the float. - Uruguay lacked a developed market for peso-denominated instruments in a highly dollarized economy, undermining post-crisis monetary operations capacity; authorities had to develop a peso market for short-term treasury bills and introduce additional instruments to regain monetary control. - Central banks fostered market development by reducing issuance of nonmarketable securities, using central bank bills for operations, creating infrastructure, setting repo standards/reference rates, ending single market-maker roles, and deregulating markets. ### FX intervention policies and transparency - Transition required coherent intervention strategies covering objectives, timing, and amounts for both orderly and disorderly exits. - Many countries gradually adapted intervention mechanisms as flexibility increased; direct market interventions were used to smooth volatility within bands and to support informal inner bands or undeclared targets. - In orderly exits, intramarginal interventions were gradually abandoned to enhance credibility, supported by infrequent and more transparent interventions. - Examples: - Czech Republic: fixing abolished at time of exit; managed float with an indicative nonbinding band announced. - Israel: formal policy of no intervention within the band adopted when moving to a crawling fan (mid-1997); policy aimed to minimize need for interventions. - Brazil: interventions less frequent under the float; indirect mechanisms (issuance of domestic dollar-linked debt, participation in derivatives market) used to ease pressures. - Uruguay: interventions aimed at achieving monetary and inflation goals; strategy and tactics announced at exit to restore credibility; later interventions used more flexibly and less transparently. - Transparency of intervention strategies (objectives) generally improved credibility; tactics (timing, amounts) often remained less disclosed. - Intervention volumes have been published ex post in some cases; no clear pattern of preannouncement. ### Coordination with capital account liberalization - Exits under market pressure often occurred with largely liberalized capital accounts (e.g., Uruguay open almost 30 years before exit; Brazil relatively open at float; Czech Republic liberalized inflows earlier). - In gradual transitions, liberalization was better coordinated with exchange rate flexibility: long-term inflows liberalized before short-term, and short-term liberalization often happened in tandem with rising flexibility. - Liberalizing short-term inflows before outflows created appreciation pressures that complicated macro management. - Examples: - Poland: most inflow controls liberalized before the crawling band, which was then widened in steps. - Israel: inflows liberalized before outflows; short-term inflows liberalized shortly after move to crawling band. - Chile: liberalization moved parallel to exchange rate flexibility and used market-based inflow controls to reduce short-term inflows’ component. - Authorities in Chile, Israel, and Poland liberalized some outflow transactions to reduce appreciation pressures; full capital account liberalization followed the float in these countries. - Liberalization of forward and derivative controls was typically gradual before full float, facilitating hedging and market development. ### Challenges in transitioning to greater flexibility - Common challenges: - Assessing preparedness and appropriate timing for increased flexibility. - Restoring and maintaining monetary policy credibility and finding a new nominal anchor. - Determining the central bank’s market role during and after the move. - Calibrating transparency and communication in policy implementation. - Assessing preparedness: - Abrupt exits suffered from absence of important ingredients for flexibility (Uruguay lacked derivative markets and monetary instruments; Brazil and Czech Republic adopted IT without all supporting elements). - Gradual exit countries emphasized supportive elements but still faced timing and preparedness assessment difficulties (Chile delayed exit over fears of corporate currency mismatches that proved overstated). - Restoring credibility and choosing a new anchor: - Crisis exits required rapid credibility restoration; Brazil and the Czech Republic chose swift IT adoption, investing heavily in capacity and communication. - Uruguay used high interest rates and monetary targeting as interim credibility tools while preparing for IT. - Central bank involvement: - Disorderly exits required balancing volatility control against perceptions of returning to an exchange rate target; authorities engaged in FX market until pressures subsided (Czech Republic, Uruguay). - Gradual exits reduced central bank market roles over time and abolished sole market-maker functions; widening bands and greater transparency reduced intervention volumes (Israel, Poland). - Transparency and communication: - More transparency was generally used when credibility problems existed; abandoning undisclosed inner bands improved credibility. - Countries varied in disclosing operational tactics; in some cases (Uruguay) disclosure of tactics aided credibility restoration, while others withheld tactical details to limit speculative attacks. *Source: Detailed case studies.* ### Conclusions and Lessons from the ### Conclusions and Lessons from the Country Experiences ### Findings and numbered conclusions - 1. Gradual transitions to exchange rate flexibility through increasingly more flexible forms of intermediate regimes in the interim period offer time to prepare for an orderly exit, thereby reducing the scope for policy reversals. During the gradual exits of the three countries, avoiding moral hazard (or implicit exchange rate guarantees) was essential in the transition process, with two-way risks helping to reduce both one-way bets and the scope for destabilizing market strategies. - 2. It is important to strike the right balance between caution and taking advantage of the mutually reinforcing relationship between flexibility and capacity building. A premature introduction of exchange rate flexibility can be damaging; advance preparation is essential in ensuring a smooth and successful regime change. However, too much emphasis on meeting all preconditions may unduly prolong the move to a float and even increase the risk of being forced out by the markets at the wrong time. Timely and reliable information is crucial in assessing preparedness. - 3. Experiences with disorderly exits underscore the high premium assigned by markets to a consistent mix of macroeconomic and financial policies under increased capital mobility. Capital mobility exposes inconsistencies in the macroeconomic policy mix (for example, a combination of expansive fiscal and restrictive monetary policies under a pegged exchange rate) and financial sector vulnerabilities, making the transition process more vulnerable to external pressures. Supportive fiscal policies were indeed helpful in reducing the burden on monetary policy during gradual exits, as well as in restoring monetary stability and credibility following crisis exits. A strong financial system with low FX exposure helped limit the risk of crisis exits as well as a spillover of a currency crisis to the financial sector. - 4. Coordinating the exit strategy with capital account liberalization may reduce the pressure on macroeconomic policies and help avoid disorderly exits. In many cases, establishing some flexibility prior to capital account liberalization was beneficial, and transitions to flexibility could be supported by removing existing asymmetries in the capital account (for example, by liberalizing capital outflows to reduce the appreciation pressure on the currencies from heavy inflows). - 5. Putting in place the recommended building blocks of greater exchange rate flexibility at an early stage greatly facilitates the transition to a floating regime, helps address fears of floating, and bolsters the chances of a successful exit, gradual or rapid. This process takes time and requires substantial capacity-building efforts. All four ingredients of moving to exchange rate flexibility played key roles in preparing the economies and smoothing the regime transitions. - 6. A transparent and effective communication strategy on monetary and exchange rate policies was essential in preparing the economies for greater flexibility as well as contributed to the credibility of the floating regimes, in the context of both orderly and disorderly exits. Building an effective capacity for monetary policy operations and deepening complementary markets, such as interbank money and securities markets, supported the establishment and effective implementation of the four ingredients of floating. - 7. There was no unique path to greater flexibility in terms of sequencing with the supporting elements, but some basic elements were put in place at fairly early stages and continued until the float, consistent with the suggested path in the fixed-to-float framework: laying the groundwork for an alternative monetary framework, establishing FX markets, and building FX risk management systems. Intervention policies did not involve much advance preparation; a general strategy was adopted and announced at the time of the exit. Agreement on principles and characteristics of the eventual regime was helpful in establishing guidelines and a framework for the process. - 8. Establishing the individual supporting elements can be mutually reinforcing. Introducing some exchange rate flexibility both allowed and spurred capacity buildup in gradual transitions, permitting in turn more exchange rate flexibility; over time a virtuous cycle took shape. Allowing for two-way variation in the exchange rate at an early stage (for example, by a gradual widening of exchange rate bands and limiting central bank intervention) helped stimulate FX activity and provided incentives for better risk management. In most cases market development began only after some exchange rate flexibility was introduced even though not all the ingredients of a floating regime were fully in place. Increasing exchange rate flexibility through more flexible forms of pegs was helpful in establishing remaining ingredients (capacity for risk management and an alternative monetary framework). - 9. Authorities played a crucial role: providing a stable regulatory environment and infrastructure; actively developing FX and complementary markets; central banks acting as market-makers in illiquid markets initially; issuing bills for monetary management; introducing instruments for hedging; participating in FX derivatives markets; and ceasing market-maker roles as markets matured. Authorities also built capacity to manage FX risks indirectly (by increasing FX flexibility) and directly (through regulation and monitoring). Cautious liberalization of derivative activities, with appropriate sequencing and safeguards, facilitated risk management and hedging market development. - 10. The relationship between flexibility and its building blocks may not be continuous. Providing small degrees of flexibility when several ingredients of floating are lacking may be beneficial because the former helps build the ingredients, whereas introducing too much flexibility without many of the building blocks may be risky and make the transition more challenging. - 11. In countries exiting pegs under market pressure, the lack of some or most ingredients supporting a floating regime prior to the exit complicated the transition and subsequent stabilization efforts (particularly with highly dollarized public and private sector balance sheets). Intensive capacity-building efforts were required to establish a credible nominal anchor, markets, and instruments in an unstable crisis environment. - 12. Disorderly exits can be durable even in the absence of most preconditions at the time of the exit if the lack of these elements is quickly recognized and addressed through intensive capacity-building efforts. Extensive efforts to put in place the preconditions of IT and to strengthen markets and risk management systems were essential in supporting the operation of the floating regimes, contributing to the durability of exits in crisis countries. These efforts also helped limit the severity of crises and achieve a relatively quick return of policy credibility. - 13. Transition to flexibility usually involved testing by the markets of the authorities’ commitment (in both disorderly and orderly transitions). Credibility was generally established firmly once the commitment had been tested by the markets. Experiences underscore the importance of consensus and coordination among key parties to make tough decisions, and of a commitment to maintaining consistent policies. ### Operational elements and policy implications - Early preparation and capacity building: - Build the four ingredients of exchange rate flexibility early and iteratively. - Develop interbank money and securities markets and instruments for hedging. - Strengthen FX risk management capacity across banks and corporates. - Coordination of macroeconomic policies: - Ensure fiscal policy supports monetary policy during transitions to reduce pressure on monetary authorities. - Coordinate exit strategy with capital account liberalization and remove asymmetries (for example, liberalize capital outflows when appropriate). - Market development and sequencing: - Introduce limited two-way exchange rate variation to stimulate FX activity and risk management. - Use central bank market-maker roles temporarily in illiquid markets and withdraw as markets mature. - Sequence liberalization of derivatives cautiously with safeguards to mitigate misuse. - Communication and credibility: - Implement transparent and effective communication strategies on monetary and exchange rate policies. - Secure consensus and coordination among key parties to sustain consistent policy mixes and withstand market tests. ### Role of preparedness, sequencing, and crisis response - Preparedness levels matter: reasonable preparedness facilitated smooth exits; lack of preparedness complicated transitions and required intensive capacity-building. - Sequencing is flexible: no unique sequencing, but laying groundwork for monetary frameworks, FX markets, and risk management early is common. - Crisis exits can succeed: rapid, intensive post-exit capacity building and establishment of IT and market infrastructure can restore credibility and durability even after disorderly exits. *Conclusions and Lessons from the Country Experiences* ### Part 2 ### III Orderly Transitions — Chile (1984–99) ### Summary of the transition - The transition from a crawling band to a floating exchange rate was very gradual and mostly orderly, taking about 15 years from the introduction of a crawling band mechanism to the elimination of the band in 1999. - The floating regime in place since 1999 withstood contagion pressures from crises in Argentina and Brazil in the early 2000s. - Factors that facilitated a smooth float: - Low level of exchange rate pass-through to inflation. - Limited dollarization of the banking system. - Prudent private-sector attitude to exchange rate risk. - Development of FX and financial markets over time. - Capacity to implement an alternative monetary policy framework under greater flexibility. ### Motivations and factors triggering the exit from the crawling band - The movement toward a floating regime occurred via successive adjustments to the crawling band parameters during 1984–99 to increase exchange-rate flexibility: - Gradual widening of the band. - Changes in the rate of crawl. - Discrete adjustments to the central parity: three devaluations and five revaluations. - The band was eliminated in September 1999 following a brief tightening in mid-1998 against the background of market turbulence in other emerging markets. - The band was narrowed from ±12.5 percent to –3 percent/+2.5 percent in June 1998; the CBC then widened the band daily, leading to elimination in September 1999. - Central Bank of Chile (CBC) actively intervened within the band to cope with massive capital inflows in the 1990s, raising international reserves: - CBC’s international reserves rose from US$2.6 billion at the inception of the band to US$19.2 billion in October 1997. - Reserves fell to US$14.8 billion at the time of the band’s elimination. - Policy priorities and changing economic conditions: - The crawling peg adopted in 1982 aimed mainly at preserving external competitiveness; central parity set to depreciate according to past inflation. - With an explicit inflation target announced in 1990, achieving price stability became a priority. - Strong capital inflows in the 1990s created tensions between inflation objectives and maintaining the exchange rate within the band; CBC prioritized the inflation objective. - From September 1998, the crawl rate was revised to follow expected future rather than past inflation. - The formal inflation target has been the only nominal anchor since 1999. ### External factors and timing - External developments contributed to the move to full-fledged IT and greater exchange rate flexibility: - Significant fall in GDP growth and inflation after the Asian crisis in 1997 prompted enhancement of the macroeconomic framework. - Main elements of the enhancement included adoption of a floating exchange rate regime, deepening of FX derivatives markets, and complete opening of the capital account. - International integration and capital-market developments made hybrid exchange-rate systems harder to manage; the authorities chose to float rather than adopt a currency board. - The band was abandoned during a relatively calm domestic and international period when the peso was close to the band’s center. ### Coordination of the exit with supporting elements of float - Evidence indicates Chile was prepared for floating well before 1999; supporting elements present at the time of elimination included: - Relatively low exchange rate pass-through. - Well-developed and regulated financial sector. - Highly developed derivatives and financial markets. - Low level of dollarization and limited exposure of banking and corporate sectors to FX risks. - The authorities had been implementing an implicit IT framework since 1990 and had instruments for conducting monetary policy under greater exchange-rate flexibility. ### The foreign exchange market - Development timeline and liberalization: - FX spot and derivatives markets developed steadily from 1992 until the float. - In the mid-1980s, a forward market was authorized with maturities between 15 and 180 days and market-determined forward rates. - Authorities liberalized arbitrage regulations, authorized swap transactions, eased access to the FX market, and allowed greater exchange-rate flexibility within the crawling band. - At the time of the float, the onshore spot, forward, and swap markets and the offshore NDF market were all well developed. - Market activity and hedging costs: - Turnover in the FX derivatives market rose from 0.06 percent of GDP in 1993 to 1.4 percent of GDP in 1998, and to 2.9 percent by 2003. - The spread on a forward contract fell from 26 basis points to 16 basis points between 1998 and 2003, comparable to that in OECD countries. - Overall activity in the Chilean spot FX market is not substantially different from that in more developed economies; FX derivatives activity is slightly above that in other emerging economies but considerably lower than in developed economies. ### FX risk management in banking and corporate sectors - General preparedness: - At the time of the peso’s float, both corporate and banking sectors had sufficient capacity to manage FX risks. - The financial sector was more exposed than the corporate sector, before and after the elimination of the band. - Hedging ratios and exposure: - 90 to 100 percent of bank net exposure was hedged. - 40 percent of corporate sector exposure was hedged. - Regulatory evolution and market access: - Post-1982 banking-crisis regulations initially limited mismatches to 20 percent of the absolute value of Tier I capital; several operations were excluded and separately treated. - In 1995, banks were required to finish daily with a long cash position in trading activities; FX operations and derivatives permitted only to support trade activities or investments abroad. - In August 1998, the global limit was maintained but mismatch computation distinguished among currencies. - In 1999, currency mismatch regulations were amended to incorporate all FX operations and a framework for managing liquidity and interest-rate risk was introduced. - Futures, forwards, swaps, and combinations were permitted; the authorization requirement to engage in derivatives transactions with external counterparties was eliminated by 1999. - Currency mismatches of debtors were incorporated in banks’ credit evaluation only beginning in 2000. - Corporate sector characteristics: - The corporate sector had a prudent attitude toward exchange-rate changes before the float and retained it after elimination of the band. - Firms were adequately matched in terms of currencies for the 1995–2003 period, indicating awareness of currency-mismatch risks even pre-float. - Evidence shows mismatch trend increased until 1998 but declined persistently after the 1999 depreciation and subsequent float. - FX exposure was significant for only 13 percent of publicly listed firms and affected only 17 percent of all industries in the corporate sector in the late 1990s. - Most firms were naturally hedged, being located in the tradables sector. - Share of firms hedging exposures increased from 8 percent in 1993 to 21 percent in 1998, and to 33 percent after the float (period endpoint implied in text). *Prepared by Luis Ahumada (Central Bank of Chile); Camilo Carrasco and Andrea Tokman provided discussions and understanding of policy changes during the 1990s.* ### 2003. Domestic corporations reportedly use mainly the ### _op256 - 2003. Domestic corporations reportedly use mainly the ### FX risk management and market structure - Domestic corporations reportedly use mainly the onshore market to hedge their FX exposures. - The U.S. dollar–peso forward market has the active participation of medium and large firms; the access of smaller enterprises to the forward market has been limited somewhat by counterparty credit risk and lack of sophistication. - The offshore market has been used mainly by leveraged foreign investors (Chan-Lau, 2005). - The private sector’s FX risk management capacity has been supported by: - A tightening of prudential rules (for example, minimum credit rating requirements for domestic corporations’ external borrowing in the 1990s). - The gradually widening crawling band, which likely provided a limited implicit guarantee to those holding unhedged foreign liabilities, thereby limiting unhedged exposures (De Gregorio and Tokman, 2004; and Cowan and De Gregorio, 2005). - A well-functioning and liquid forward market facilitating FX risk management. - The widespread use of dollar-peso forward operations introduced in 1992 and the deep market for peso-indexed bonds allowed market participants to hedge against currency risk. ### Monetary policy and operations - The transition in exchange rate regime proceeded alongside efforts to establish an alternative monetary policy framework to replace the exchange rate anchor and to build capacity to conduct monetary policy under a flexible regime. - Adjustments to the crawling band aimed to increase exchange rate flexibility and were accompanied by efforts to reduce inflation through a gradual adoption of a full-fledged IT framework (Céspedes and Soto, 2005). - From 1989, a pre-announced inflation band target coexisted with the crawling band. - Full-fledged IT was introduced with the elimination of the crawling band; the inflation target, under a fully floating exchange rate, became the sole anchor for inflation expectations. - Elements in place before the exit to the floating regime in 1999 included: - The autonomy of the CBC since 1989. - Well-developed and liquid financial markets. - An effective capacity to conduct monetary operations. - A reasonable capacity to model and forecast inflation. - The CBC gained credibility by meeting (implicit) inflation targets and improved transparency through regular inflation reports and release of minutes of policy meetings. - Daily interbank rate targeting was implemented from 1995, reflecting a reasonably good understanding of the monetary transmission channel and modernization of monetary policy procedures. ### FX intervention strategy - Under the crawling band, foreign exchange market interventions were common and expected; the CBC had authority to intervene at its discretion, and intramarginal interventions were frequent during the 1990s. - After elimination of the band, a free floating exchange rate system was adopted and a new intervention strategy was announced: - The CBC abandoned the commitment to keep the peso within a band but announced the possibility of intervention in exceptional situations involving a sudden increase in exchange rate volatility, with a view to dealing with external and/or internal instability and reducing the speed of currency depreciation. - No explicit predetermined rule for intervention was established, but explicit communication of intervention intensity was considered important for credibility. - Interventions were made transparent and details announced in advance, including the specific period during which the CBC could intervene and the maximum amounts to be used. - Interventions aimed at signaling that the authorities considered the evolution of the exchange rate not justified by fundamentals and that the extent of the depreciation was excessive (De Gregorio and Tokman, 2004). - The CBC intervened in the market twice since 1999: - First in August 2001 (response to regional financial disorder caused by the crisis in Argentina and then the turbulence after September 11); the CBC announced it could intervene from that date to the end of the year and announced the resources available for intervention. - Second in October 2002, attributed to pressures on the Brazilian real. - Both attempts are considered to have been successful. Similar announcements were made in October 2003 for possible FX intervention (Tapia and Tokman, 2004). ### Sequencing with capital account liberalization - Chile’s capital account liberalization gradually moved parallel to its exchange rate liberalization (Le Fort-Varela, 2005). - Regulatory adjustments aimed to support the crawling band by reducing net inflow of capital and stemming peso appreciation; following surge in capital inflows, capital outflows were gradually liberalized along with widening of the band. - Controls on short-term capital inflows were imposed from June 1991 to retain the possibility of managing the exchange rate with an independent monetary policy: - Controls were primarily market based, in the form of an unremunerated reserve requirement, and were tightened several times to increase the rate or broaden its scope (see Ariyoshi and others, 2000; and Le Fort-Varela, 2005). - The inflow controls were lifted in 1998, and all remaining controls on inflows and outflows were removed in 2001, well after the regime shift. - Controls on derivatives transactions were relaxed from the mid-1990s to 1999 to facilitate handling of FX risks under more flexible exchange rates. - Notable liberalization steps and regulatory changes cited: - Minimum time to repatriate capital and earnings for FDI capital was reduced successively during 1991–93 from 10 years in 1985 to 1 year in 1993, and eliminated in 2000. - Banks were allowed to invest abroad up to 40 percent of their funds collected as term deposits in 1991. - Amounts that pension funds were allowed to invest abroad were increased successively during 1992–99. ### Other supporting elements - At the time of the move to a floating regime, the banking sector was sound and compliant with supervision and regulation. - The banking sector had a sustained large capital base and kept a low level of dollarization, accompanied by a strict regulatory and supervisory framework that limited banks’ exposure to credit and currency risks. - Chile successfully created a unit of indexation to hedge inflation risk, widely used in deposit contracts and to finance long-run real estate loans since the early 1980s. - The quality of the loan portfolio was high, with nonperforming loans reaching at most 3 percent of total loans under the worst-case scenarios before the Asian crisis. - A well-developed domestic capital market supported the flexible exchange rate regime: - Firms issued long-term bonds denominated in Chilean pesos to reduce FX exposures. - Development of the capital market was due in part to the increasing importance of institutional investors, mainly pension funds, which made up a sizable share of the demand for debt instruments through the 1990s. - A prudent fiscal policy was a key ingredient in Chile’s success in disinflation and transition to a new nominal anchor: - Fiscal authorities managed to maintain a fiscal surplus, allowing monetary authorities to implement a policy that lowered inflation from two-digit chronic levels to those observed in developed countries. ### Challenges faced and lessons from Chile’s transition experience - The transition to a full float was lengthy—about 15 years—because of emphasis on supportive elements for a floating regime; essential conditions were in place well before the float. - The trigger for the decision to float appears to have been the incompatibility of prevailing multiple monetary objectives. - Main challenge was determining whether the economy was sufficiently prepared for the floating regime; assessing preparedness and timing was difficult. - Authorities feared that liberalization of the exchange rate and associated volatility could endanger the low and stable inflation goal and central bank credibility, and threaten financial stability. - Fear of losses from currency mismatches in the corporate sector and potential pass-through of exchange rate changes to inflation contributed to delaying the exit by several years. - Lack of reliable and prompt information impeded assessment of preparedness: - The degree of exchange rate pass-through, considered high, was actually decreasing over the 1990s and hence was overestimated, especially regarding the CPI inflation index. - Lack of reliable prompt information about private sector balance sheets and uncertainty about the development of the domestic derivatives market undermined assessment of potential negative consequences of a sudden exchange rate depreciation. - Mismatches turned out to be less substantial and availability of hedging better than assumed. - Lessons drawn: - The gradual evolution of exchange rate flexibility and capital account liberalization can support each other. Gradual increase in exchange rate flexibility helped Chile integrate with capital markets while lessening risks. Gradual liberalization of capital outflows, more cautious liberalization of short-term inflows, and early liberalization of derivative transactions facilitated integration as market participants gained expertise and monetary authorities prepared for a full float. - Early preparation helps address fears of floating and increases chances of a successful and smooth exit. Building capacity to manage FX risks, implement monetary operations, develop FX markets, and prepare since the early 1990s for an alternative monetary anchor toward full-fledged IT were vital. The CBC’s transparent and effectively communicated intervention strategy contributed to credibility of the floating regime and IT framework. - The availability of a timely and adequate information base is crucial in assessing preparedness. Prompt information on private sector balance sheets and on dynamics between the exchange rate and inflation could have helped avoid undue delay in moving to greater flexibility. - The Chilean experience illustrates the mutually reinforcing relationship between greater exchange rate flexibility and market and capacity building: introducing greater flexibility through a gradually widening crawling band encouraged better FX risk management and spot and forward FX market development, supporting the move to a fully flexible exchange rate regime in 1999. - Building a sound financial system and a deep capital market is crucial to avoid potentially disruptive consequences of a move to a flexible exchange rate regime. Strict supervision and regulation of the banking system, emergence of a large institutional investor base, and introduction of various financial instruments (for example, inflation-indexed bonds) were helpful in coping with greater exchange rate volatility under the floating regime. *Italicized source attribution: _op256 - 2003. Domestic corporations reportedly use mainly the* ### 23.9 percent (euro). ### _op256 - 23.9 percent (euro). ### From crawling fan to free float — key developments and numerical milestones - Upper (depreciation) slope left at 6 percent; width of the band increased constantly over time. - Width of the band was increased asymmetrically to approximately ±14 percent (weaker/upper limit raised; stronger/lower limit left unchanged, with reduced slope). - With adoption of the crawling fan, market intervention by the BoI effectively stopped in June 1997 (except for a few days later that year) and nonintervention was maintained until formal abolition eight years later. - The band was formally abolished in June 2005, by which time the band had a width of about 62.5 percent around a theoretical midpoint. - De jure preservation of the band after de facto irrelevance owed to: - Difficulty identifying loss of significance in real time. - Belief that the band’s existence affected market behavior and its abandonment could be destabilizing. - Opposition due to perceived greater freedom for the central bank. ### Coordination of regime transition with supporting elements - Supporting elements coordinated with each stage of transition: - Development of the FX market. - Intervention policy reform. - Capital account liberalization. - Ensuring financial system stability. - Effective monetary policy and instruments. ### Foreign exchange market development — timeline and mechanisms - Until May 1990: BoI was sole market maker operating an administrative fixing (commercial banks reported net supply/demand; central bank set one rate). - May 1990: BoI introduced an electronic trading platform with a single daily multilateral trading session (BoI-managed auction; single final rate = official exchange rate). - July 1994–April 1995: BoI phased out multilateral trading; abolished it in April 1995; banks moved to bilateral over-the-counter continuous interbank trading. - Market deepening features: - Entry of interbank brokers, foreign financial institutions, electronic trading. - Addition of derivative products including swaps and options. - FX hedging market growth before the de facto float in 1997; BoI issued financial instruments in 1989 to kick-start futures and options markets. - Gradual removal of restrictions on forward transactions by tenor (first up to one month, then three months, then six months, then one year), and continued documentation requirements for options to prove hedging use. ### FX hedging and prudential safeguards - Authorities recognized derivatives could facilitate speculation; forward transactions played a major role in speculative attacks on the sheqel. - Safeguards during liberalization: - Documentation requirements for underlying transactions for a considerable period. - Staged permissions by tenor for forward transactions. - Options market promoted but documentation required to prove hedging intent. - Banks’ direct and indirect FX exposures incorporated into prudential systems (forward exposures in open FX positions and capital requirements). ### FX intervention policy evolution and outcomes - Intervention policies evolved gradually toward greater flexibility; tactics often ad hoc and sometimes incoherent (costly for credibility/financially). - During horizontal and crawling bands, exchange rate was often much less variable than band permitted; BoI intervened regularly and often attempted to steer within an informal “inner band.” - Distribution of exchange rate was asymmetrical; rate most frequently in the lower (stronger) part of band. - BoI resisted nominal depreciation more strongly than appreciation due to disinflationary priorities and pass-through concerns. - Mid-1995: BoI reduced intervention; ceased totally for some months in 1996; resumed in August 1996 as inflows pushed rate to lower edge; intensity grew until June 1997 when intervention effectively stopped with the crawling fan. - Fall 1998 test: contagion from Russian debt crisis and LTCM precipitated rapid depreciation; tolerance for large moves without intervention helped establish monetary policy credibility. - Means of intervention shifted with market development: sole market maker era → multilateral trading era → continuous interbank trading era. When policy limited intervention to band limits, timing/quantity issues were largely resolved. - Policy transparency increased over time; formal policy of nonintervention within the band was eventually adopted and gained credibility. ### Other supporting reforms (financial system, capital account, monetary instruments) - Government and BoI reduced direct roles in allocation of credit and interest rate determination. - Capital markets developed: increased issuance of standardized marketable securities, including long-term nominal bonds. - Capital account liberalization sequenced gradually: - Liberalization of inflows began in 1988; restrictions on outflows lifted beginning in 1992. - Restrictions lifted earlier for long-term flows (two to three years before short-term flows). - Sequence by sector: nonresidents → business sector → households → institutional investors. - Monetary instruments for transition to IT: - Reserve requirements drastically reduced. - Short-term central bank bills introduced. - Policy interest rate became primary channel of monetary policy. - Financial stability measures and prudential reform: - After 1983 banking crisis, supervision improved; by move to free float banks had strengthened capital bases and modern market risk techniques. - 1985: limits on open FX positions enacted. - By 1997: banks required explicit FX exposure management policies and reporting to supervisor and public. - 1999: stress testing introduced. - Specific prudential steps at times: capital charges against FX exposures (in 1998, raised in 2004), additional provisions against FX credit to borrowers with no FX income, maintenance of required minimum FX liquidity (in 2003). ### Summary and lessons from the Israeli experience — distilled lessons (bullet points preserved) - Israel chose a gradual approach to exchange rate flexibility; gradualism produced steady progress and mostly avoided crises and policy reversals. - Coordination of exchange rate flexibility with reforms across the economy and financial system proved mutually reinforcing. - Increased exchange rate flexibility accompanied opening of the economy and greater integration in the international financial system. - Lessons learned: - Although both exchange rate flexibility and capital account liberalization proceeded gradually, increased exchange rate flexibility generally preceded capital account liberalization. Flexibility of the exchange rate was needed to obtain benefits of capital mobility while lessening its risks. - Avoiding moral hazard was essential. FX risk was made explicit and responsibility to manage it imposed on those who incurred the risk (banking and nonfinancial business sectors). The BoI’s ability to adopt and maintain nonintervention provided strong incentives for private-sector risk management. - Availability of an alternative monetary anchor and operating tools built over time were vital. Exchange rate flexibility without credible and effective policy for maintaining price stability would have endangered progress on macroeconomic stability. ### Poland (1990–2000) — transition stages, motivations, and numeric milestones - Characterization: gradual, step-by-step, orderly process about 10 years (1990–2000) from exchange rate targeting toward direct IT with fully floating exchange rate. - Five main stages of exchange rate regime evolution: - Fixed peg (administrative fix) to U.S. dollar (January 1990–October 1991). - Preannounced crawling peg (October 1991–May 1995). - Crawling band, widened in several steps (May 1995–July 1998). - De facto float with formal wide crawling band (August 1998–April 2000). - Free float (since April 2000). - Key numeric outcomes and dates (extracted from the evolution narrative and Table 8): - Inflation reduced from four-digit levels to 249.3 percent by end-1990 and 60.4 percent by end-1991 (targets were 95 percent and 32 percent respectively). - May 17, 1991: zloty fixed to basket of five currencies (US$–45%, DEM–35%, GBP–10%, FRF and CHF–5%) and devalued against the U.S. dollar by 14.4%. - October 14, 1991: crawling peg introduced (monthly rate of crawl: 1.8%) with formal fluctuation band of ±2.0% and NBP’s margin of ±0.5%. - February 26, 1992: zloty devalued against the basket by 12.0%. - August 27, 1993: monthly rate of crawl: 1.6%. - September 13, 1994: monthly rate of crawl: 1.5%. - November 30, 1994: monthly rate of crawl: 1.4%. - February 16, 1995: monthly rate of crawl: 1.2%. - March 6, 1995: NBP’s margin increased to (2.0%). - May 16, 1995: fluctuation band increased to ±7.0%; NBP intervenes in the FX market both directly and indirectly. - December 22, 1995: revaluation of the central parity rate by 6.0%. - January 8, 1996: monthly rate of crawl: 1.0%. - February 26, 1998: monthly rate of crawl: 0.8%; fluctuation band increased to ±10.0% and reduction in the scale of direct FX interventions. - July 17, 1998: monthly rate of crawl: 0.65%. - July 31, 1998: final abolition of direct interventions on the FX market. - September 10, 1998: monthly rate of crawl: 0.5%. - October 13, 1998: public commitment by the MPC to float the zloty at a future date. - October 29, 1998: fluctuation band increased to –12.5%. - January 1, 1999: new currency basket (EUR–55%, US$–45%). - March 25, 1999: monthly rate of crawl: 0.3%; fluctuation band increased to ±15.0%. - June 7, 1999: abolition of fixing transactions (indirect interventions). - April 12, 2000: formal introduction of the floating exchange rate regime; following this, NBP ceased to announce central parity and fluctuation band and has not intervened in the FX market since. ### Poland — supporting elements and market development - Monetary operations and financial market development: - Interbank deposit market developed first, facilitating liquidity management. - Unified bank accounts in the NBP established in 1993–94; averaging in required reserve at end-1994. - Repurchase operations introduced in 1993; book-entry system for treasury bills and NBP bills in 1995. - Reissue of NBP money bills began in 1994; these became main open market tool. - Reference WIBOR-WIBID rates became reliable indicators. - Domestic bond market deepened: shift from short-term bills to fixed rate bonds; first international placement in 1995. - Since 1998, FX swaps became the most liquid component of the domestic money market. - FX and derivatives market development: - Until 1995, NBP acted as sole market maker in interbank FX market; greater flexibility and market-based operations expanded from mid-1990s onward. *Italic: IMF content unit summarized from _op256 - 23.9 percent (euro).* ### introduction of the crawling band in 1995 was a stimu- ### _op256 - introduction of the crawling band in 1995 was a stimu- ### Development of FX and Derivatives Markets - Introduction of the crawling band in 1995 stimulated development of the spot market and the rise of the forward FX market, facilitating hedging against FX risks. - By 1998, the spot FX market was well developed; derivatives markets developed more gradually, with a significant pickup in the year before the float. - Authorities faced a trade-off between benefits of hedging instruments and risks of facilitating speculation; use of derivatives augmented appreciation pressure on the zloty in 1998. - Maintaining restrictions on derivative transactions risked pushing activity offshore; a vibrant zloty NDF market emerged in London and practically ceased to exist onshore by 1999. - In 1998, the Ministry of Finance’s interpretation of the Foreign Exchange Law of December 18, 1998, made the Polish zloty externally convertible and treated FX swaps as not requiring an NBP permit, facilitating FX swap transactions. - The swap market developed dynamically since 1999; a deep onshore FX swap market developed quickly and squeezed out the offshore NDF market in 1999. - Higher liquidity in the swap market was supported by growing nonresident exposure in zloty-denominated treasury bonds. - Prudential safeguards used when liberalizing transactions: FX exposures associated with derivatives were included in limits on open FX positions and capital requirements. ### Foreign Exchange Intervention Policy - Early transition years: commercial banks were obliged to conduct FX operations with the NBP; NBP was sole market maker until May 1995. - From 1995, NBP conducted two types of FX interventions: “direct” (central bank dealers) and “indirect” (fixing transactions). - Direct interventions maintained an unofficial (inner) intervention range within the band; fixing allowed each domestic commercial bank one FX transaction with the NBP at the end of each working day to help small banks close open positions. - Initially, indirect interventions predominated; over time the size of both operation types became more balanced. - In 1995 the value of fixing transactions was more than five times higher than direct transactions; in 1997 the volume of fixing transactions surpassed that of direct interventions by 65 percent. - Until mid-1997, NBP limited flexibility within informal inner limits on the appreciation side to resist appreciation pressures; tolerance for depreciation was higher (example: July 1997 reluctant reaction to sharp depreciation). - August 1998 contagion from the Russian debt crisis caused rapid fall of the zloty; absence of NBP reaction made depreciation short-lived. - With evolution to greater flexibility, NBP ceased direct interventions; fixing arrangement abolished in June 1999. - After official floating, NBP retained the right to intervene to achieve the inflation target but has not done so. ### Current and Capital Account Liberalization - Current account liberalization was faster than capital account liberalization, which was conducted very gradually. - Capital account liberalization was pragmatic and sequenced with macroeconomic prerequisites: declining inflation and interest rate differentials. - Sequence: FDI inflows liberalized first; after reductions in interest rate differentials and increased exchange rate flexibility, long-term portfolio flows (first inflows, then outflows together with FDI outflows) and long-term credit flows were liberalized. - Short-term capital movements (first inflows, then outflows) and derivative transactions were liberalized only after introduction of the (initially de facto) floating exchange rate regime. ### Role of Central Bank Communication - Proper communication and explanation were key supporting elements of transition to flexibility. - NBP announced the decision to move to the crawling band in May 1995 in early April to allow time for banks and economic agents to prepare. - Intent to introduce an IT framework implying increased exchange rate flexibility was first announced in early June 1998 by the MPC; the objective to move to the float was officially announced only in October with the Medium-Term Strategy of Monetary Policy (1999–2003) (MPC, 1998). - Operational decisions were communicated with limited transparency to avoid speculative activity: some announced the day before implementation (e.g., December 1995 revaluation of the zloty, all crawling rate reductions, widening of fluctuation bands); some not announced at all (e.g., introduction/change of unofficial intervention level in 1995 or withdrawal from direct FX interventions). - Official decision to adopt floating system was communicated in the afternoon of the day before implementation, after domestic FX market close. ### Other Supporting Elements (Financial Stability, Regulation, Coordination) - Early 1990s banking sector: undercapitalized, poorly managed, segmented; accumulation of bad loans prompted exceptional measures to capitalize banks and restructure bad loans. - Strengthened supervision, restrictive standards, privatization, and foreign investment improved debt quality, increased capital base, and introduced modern market risk management techniques. - Tight prudential regulation, strong offsite and onsite inspections, and tight limits on open FX positions were maintained throughout the transition. - Ordinance of March 19, 1993: net open position of a bank in individual currency limited to 15 percent of its capital. - Banks generally maintained balanced positions and used limits incidentally; limits stimulated spot and derivatives market development as banks closed positions in the market. - Specific capital requirements on FX risk and close monitoring of FX risks were adopted only after the float, through EU harmonization directives adopted in 2001. - Coordination between NBP and Ministry of Finance institutionalized via the Public Debt Management Committee to exchange information and coordinate measures to reduce market volatility from large-scale public debt management or privatization operations. ### Lessons from the Polish Experience - The zloty’s float helped reduce vulnerability to currency risk; the gradual approach helped economic agents cope with higher exchange rate volatility. - Transition to flexibility was facilitated by coordination with development of financial markets and institutions, stability and strength of the financial system, and monetary policy strategy; evolution was associated with cautious capital account liberalization. - Gradual transition should be accompanied by a proper communication strategy: regime changes communicated in advance, operational decisions conveyed the day before or not announced, helping avoid speculative activities. - Transition required tough, consistent decision making and coordination between the central bank and government; once decisions were made they were never revoked — policy reversals would have damaged central bank credibility with large costs to the economy. *Source: Poland (1990–2000) section of the provided IMF content.* ### 5.3 percent in 1995 to 20.9 percent in 1998, causing the ### _op256 - 5.3 percent in 1995 to 20.9 percent in 1998, causing the ### Exchange rate regime, futures operations, and sovereign cost - From 5.3 percent in 1995 to 20.9 percent in 1998, causing the government to incur a predominant part of the financial cost of the depreciation. - The CBB engaged in transactions in the futures market during the peg system. - In the 1999 agreement with the IMF, the government committed to refrain from using futures market operations. - Under the new regime, the government issued securities with an exchange swap transaction during the period of market pressures in 2002. - Those operations, coupled with the exchange rate depreciation of the period, led dollar-linked debt to reach a maximum share of 41 percent of federal domestic debt in 2002. - With the recovery of confidence and a policy to reduce such debt—including the conduct of reverse exchange swap operations—the share of dollar-linked debt fell to 1.2 percent at end-2005. ### Financial system condition and restructuring - The financial system was in reasonably good condition at the time of the float after having undergone a large adjustment in previous years to adapt to the low-inflation environment. - Stabilization forced considerable adjustment by financial institutions; some, including large banks, faced significant difficulties. - The Program of Incentives to the Restructuring and Strengthening of the National Financial System launched in 1995 restructured the private financial system through mergers and acquisitions by foreign banks and some liquidations. - By the time the peg system collapsed, private financial institutions had already completed the adjustment. - The state-owned bank segment was undergoing restructuring through the Program for Reducing the Presence of the State Public Sector in Banking Activity. ### FX exposure, dollarization, and hedging arrangements - The financial system was not dollarized, reflecting FX regulations that limited pronounced exposure to FX risks. - Banking deposits or payments in foreign currency were not permitted. - External loans were on-lent with obligatory dollar-indexed clauses, avoiding mismatching between assets and liabilities. - The depreciation of the domestic currency during the crisis exit did not produce significant losses for the financial system; the system was not exposed to risks associated with an exchange rate depreciation. - Many financial institutions were trading against the sustainability of the bands through derivatives contracts and were exposed to risks associated with an appreciation of the domestic currency. ### Prudential regulation and market risk assessment - Prudential regulations requiring financial institutions to hold capital against FX risk were not in place at the time of the float. - There were limits on amounts of foreign currency purchased and sold in the spot market, but no limit on the global exchange rate risk exposure of financial institutions. - Positions in the derivatives market were not considered in those limits. - Given a long history with pegged exchange rates and steady adjustment in previous years, market participants were not accustomed to routinely assessing exchange rate risks posed by regular market volatility. - A few months after the crisis, monetary authorities set forth specific regulations limiting the exposure of financial institutions to exchange rate risks. - Footnote detail: There was a specific limit on long positions (amounts exceeding those limits should be deposited in the CBB) and a limit contingent on banks’ adjusted net worth for short positions, both in the spot market. The limits on the short position in the spot market were abolished in October 1999 and on the long position at the end of [text truncated in source]. ### Sectoral exposure: private vs public - The nonfinancial private sector was not exposed to unhedged exchange rate risks. - The nonfinancial private sector increased external debt but benefited from hedging mechanisms: - foreign currency proceeds for exporters, - large remittance of flows abroad prior to the collapse of the peg system, - issuance of domestic dollar-linked public debt, - derivative transactions. - Some private agents were exposed to exchange risks through dollar-linked leasing contracts, but those operations were not significant in the system. - The public sector was vulnerable to depreciation of the real because of issuance of external debt, domestic dollar-indexed securities, and derivative transactions. - As a result, the government incurred most of the financial distress. ### Monetary policy institutional framework and inflation targeting - The CBB had created the Monetary Policy Committee (Copom) in June 1996. - Minutes of Copom meetings began being published in March 1998. - There was a need for greater transparency and further progress in ensuring the CBB’s operational independence. - Significant progress was achieved with the adoption of IT (inflation targeting): level of transparency increased and the CBB gained greater credibility. *Source: IMF PDF content unit provided.* ### 2005. For the prudential regulation on the foreign exchange market ### _op256 - 2005. For the prudential regulation on the foreign exchange market ### Brazil: transition to a floating exchange rate and adoption of inflation targeting (IT) - Background and institutional context - Price stability appears among other central bank objectives in legislation enacted in 1965; in practice it became the primary commitment of the CBB. - De jure central bank independence has not been adopted, although the CBB has been de facto independent in conducting monetary policy. - Monetary policy instruments and capacity to affect interest rates were well developed before the float and improved during the transition. - The government securities market was well developed with substantial trading volumes and high liquidity supporting monetary operations. - During the peg system, Copom set targets for two interest rates on discount loans, which by arbitrage led to the formation of the Selic overnight interest rate (rate on overnight repurchase (repo) operations between banks, with government securities as collateral). - Greater use of open market operations occurred during 1998. The CBB suspended both discount rates following the float. In March 1999 the CBB began setting targets for the Selic rate determined by its interventions instead of banks’ arbitrage operations; the Selic rate became the main reference for other interest rates. - Capital account and liberalization - Transition to the floating exchange rate system took place in the context of a fairly open capital account. Brazil had gradually liberalized its capital account during the 1990s. - Restrictive measures on inflows were adopted from 1993 through 1996 and relaxed starting in 1997; further liberalizing measures for outflows were introduced to reduce net inflows without affecting integration with financial markets. - After the float, further liberalizing measures were introduced. - Brazil accepted the obligations of IMF Article of Agreement VIII in November 1999. - Examples of liberalizing measures noted include reduction and elimination of minimum maturity requirements for external loans, reduction to zero percent of the financial transaction tax on foreign investment in fixed-income funds and on external loans with average maturity above 90 days in 1999, regulation allowing nonresidents to invest in the same instruments as residents, consolidation of regulation on external loans and debt securities in 2000 (ending prior CBB approval requirement), permission for prepayment of external debt and regulation of issuance of real-denominated external debt in 2004, and more direct procedures and clearer rules for conversion of domestic currency into foreign currency in 2005. - Challenges during the transition - Main challenges: curb market panic, restore foreign investors’ confidence, and prevent return of high inflation. - Exchange rate depreciation, absence of an anchor for inflation expectations, and memories of high-inflation period fueled fears of return to high inflation. - Analysts predicted double-digit inflation for that year; some forecasts reached as high as 80 percent, with considerable uncertainty about pass-through from exchange rate to prices. - The CBB raised the base interest rate substantially after the depreciation, later reversing hikes as macro conditions improved; interest rate cuts began from April 1999. - The revised IMF-supported program in November 1999 pioneered use of inflation targets as part of program conditionalities. - External financial support from the IMF and active government relations with international banks helped restore capital flows and maintain trade/interbank lines. - Capital flows resumed as panic reversed and macro conditions improved. - Adoption and implementation of IT - Authorities declared intention to put IT in place in a joint statement with the IMF in February 1999; government announced goal to bring inflation down to a single-digit annualized rate by the last quarter of 1999 and to adopt IT by the end of June 1999; IT was implemented within six months and targets were set for 1999, 2000, and 2001. - Rationale for IT: anchor inflation expectations, reduce uncertainties, avoid reinstating a pegged anchor that had lost market trust, and provide an explicit anchor in an environment of high uncertainty and weaknesses in monetary institutions. - Implementation challenges: adoption amid great uncertainty and sharp depreciation; goal not only to maintain low inflation but to bring it down; build credibility of the monetary authority and develop monetary institutions; rapidly build technical capacity including forecasting models; short sample size for estimating inflation dynamics given less than five years of prior stabilization. - Mitigating actions: coherent conduct of monetary policy under IT, intensive communication (publication of quarterly Inflation Report and timely release of Copom minutes), and investment in research and modeling at the CBB. - Fiscal policy and policy mix - Government implemented a new fiscal policy regime to stabilize the economy and prevent return of high inflation; fiscal tightening that started in 1998 contributed to restraining exchange rate pass-through to inflation. - New restrictive fiscal measures were introduced in 1999 as part of a three-pillar policy mix: IT, a floating exchange rate, and a sound fiscal policy. - Fiscal adjustment had to cope with fiscal effects of currency depreciation; economic turmoil created better political conditions for fiscal turnaround. - Primary surplus rose by 3.3 percentage points of GDP during 1999 and has reached record highs recently as a continuation of the transition policy. - Key outcomes and supportive measures - Combination of tighter fiscal and monetary policies, adoption of IT, and external financial support was crucial to reverse inflation expectations and bring inflation down; in early 2000 inflation expectations fell below 7 percent. - After peaking in early 1999, inflation fell and the real stabilized; panic was reversed by mid-1999. - Lessons from the Brazilian experience (explicit bullet lessons preserved) - A pegged exchange rate system that generates increasing external imbalances and is coupled with an unsound fiscal policy would not be sustainable. - A transition to a floating exchange rate system should be planned to avoid the risk of being caught unprepared, and should be accompanied by the announcement and possibly implementation of the new regime to replace the exchange rate anchor. - A transition to a floating system in a situation of fiscal and external imbalances leads to a high degree of uncertainty, calling for tight fiscal and monetary policy. - A financial system with low exposure to exchange rate risks, coupled with prudential regulation that deals with such risk, contributes to a softer landing after a crisis exit. - The adoption of IT could be essential to establishing a new credible monetary regime that preserves stabilization gains previously achieved, in particular in the context of uncertainty and developing monetary institutions. - Although more advanced planning for the implementation of IT could have resulted in a smoother transition, it was possible to implement the new framework rapidly and successfully, owing to both the determination of the CBB to put in place the essential elements that comprise a full-fledged IT regime and the supportive fiscal policy. --- ### Czech Republic (1996–97): exit from a horizontal band and adoption of IT - Background and motivations for exit - The Czech Republic abandoned its horizontal band regime in June 1997 without an exit strategy after a mini currency crisis triggered by macroeconomic and structural policy factors. - The mix of expansionary fiscal policy and contractionary monetary policy, slow structural reform progress, and a largely liberalized capital account made the pegged regime increasingly unsustainable. - The basket peg within a ±0.5 percent band had helped stabilize inflation after price liberalization and provided an initially depreciated parity cushion. - Full current account convertibility was achieved in 1995; opening brought large capital inflows with a significant volatile short-term component, exposing monetary policy to the “impossible trinity” dilemma. - Money targets were repeatedly missed and disinflation slowed; the exchange rate band was widened to ±7.5 percent in February 1996 but this provided only temporary relief. - Without sufficiently tight fiscal policy, monetary tightening from 1996 attracted additional short-term inflows that put further pressure on the exchange rate; sustainability of the peg became hostage to potential reversal of short-term inflows. - Nature and management of the exit - Characterized as a mini-crisis exit following temporary capital flight. - Despite the crisis, outcomes were relatively contained: - The koruna depreciated by a mere 13 percent. - Reserves loss was minimal: only about 20 percent of reserves was used to defend the peg and was soon replenished. - Interest rates, which had more than doubled previously, started to ease shortly thereafter. - No spillover to the banking and financial sector occurred. - Decision to float announced relatively quickly during a calm moment in the crisis and followed by announcement of intention to focus on long-term price stability; temporary indicative bands under a declared managed float were announced and market calmed. - Policy responses and structural measures post-exit - Authorities took measures to improve macroeconomic management: reduce fiscal imbalances, address labor market imbalances, launch program to attract FDI, and speed up structural reforms including privatization of the banking sector. - Adoption of inflation targeting as the new nominal anchor and implementation of IT played an important role in limiting severity of the crisis following the exit. - Preparedness and coordination with supporting elements of a flexible regime - The exit was abrupt and not associated with a specific strategy to prepare the economy for flexible exchange rates; no alternative monetary policy framework had been planned to replace the peg. - Some exchange rate flexibility had been introduced (widening of horizontal band) but not as part of a deliberate process to establish supporting elements of a new monetary regime. - After a short period of heavily managed floating with CNB interventions on both sides of the indicative band and rising inflation, IT was adopted as the new monetary policy regime. - At adoption of IT, some key conditions were in place: central bank operational independence, effective implementation of monetary policy, availability of a key policy rate, reasonably developed financial markets, and no fiscal dominance. - Missing or weak conditions at adoption included: price stability mandate, political/public support, a strong state-owned banking system, adequate forecasting capacity, accountability, and transparency; these absences contributed to early credibility challenges. - Financial markets, instruments, and monetary policy implementation capacity - Well-developed spot and derivatives FX markets, interbank money markets, and secondary securities markets by mid-1994 allowed CNB to abandon market-maker role and conduct repo operations through the open market. - Banking reserves replaced monetary base as operational target in second half of 1994; CNB shifted toward money market interest rate targeting in early 1996 as markets developed. - By late 1995 markets were functioning sufficiently to permit monetary transmission via money market interest rates. - Elements of an interest rate corridor emerged in 1997 and were finalized in 2001 (two-week repo rate supported by standby deposit and lending facility). - A variety of market-based instruments existed; repo operations fully replaced refinancing credit auctions after mid-1994. - Some operations at the three-month maturity were abandoned in 2001; refinancing operations at the discount rate were abolished in 1996. - Banking sector resilience and prudential framework - The Czech financial system came through the FX crisis largely unscathed; main reason was good capacity to manage FX risks acquired earlier. - Banks reacted promptly: active liquidity management, daily closing of FX positions, imposing credit restrictions, and adjusting deposit and FX conversion rates for clients; FX transactions during the crisis had a positive impact on profits for a vast majority of banks. - No worsening of loan quality associated with the crisis because FX-denominated loans were either covered by foreign currency proceeds, hedged through instruments, or provided only to first-rate clients (often foreign banks). - Banking system in mid-1990s had vulnerabilities: solvency problems in small banks, slow privatization of major banks, inefficient and noncompetitive structure, low intermediation and maturity transformation, large spreads, segmented credit markets, and weak legal environment relative to neighbors. - Strengthening of prudential and regulatory framework was gradual during the 1990s and not directly associated with greater exchange rate flexibility. - Limits on banks’ open FX positions existed from early 1990s; other FX-risk prudential regulations including capital adequacy rules for foreign exchange risks came into effect only in 2000. - Strengthening actions in late 1993 included tougher licensing and asset classification, adaptation to international and EU-compatible accounting standards, restrictions on investment in certain sectors, and requirement to make capital provisions on anticipated portfolio losses. - Consolidation program following forced administration and collapses in 1994–95 improved condition of small banks; state stabilization program for small banks in 1996 purchased nonperforming loans at face value against obligation to write them off within seven years and applied performance criteria; privatization program for major banks began after 1997. - Most bank failures during consolidation were attributed to fraud, credit risk, and bad management rather than exchange rate exposure. - Permitting branches of foreign banks to operate as subsidiaries or branches proved an important stabilizing element for the banking system during the FX crisis. *Source: _op256 - 2005. For the prudential regulation on the foreign exchange market* ### Box 2. Czech Republic: The Condition of the Financial System ### Box 2. Czech Republic: The Condition of the Financial System ### FX market framework and interventions - FX-risk-related prudential regulations came into effect only in 2000 in the context of EU harmonization rules that established capital adequacy rules for FX risks. - The FX market intervention strategy developed gradually alongside the exchange rate regime and FX market development. - Interventions were first used after the widening of the band in early 1996 and became a standard policy tool since the exchange rate was floated in 1997. - Interventions were used as a standard, though infrequent, tool to stabilize market fluctuations, including in response to large capital flows that could threaten the inflation target. - Interventions were based on limits and goals set by the Board, and implemented through major market players by operative decisions of the staff without a predetermined system of allocation or bank rotation lists. - The volumes of interventions have been published with a two-month lag since 1998, but no procedural rules exist as to whether the interventions are announced immediately; both practices have been used with varying success (Holub, 2005). ### Challenges faced during the transition (peg → float; introduction of IT) - The authorities had very little preparation time (six months) to replace the exchange rate anchor with an alternative monetary policy framework under near-crisis conditions. - Public support and awareness - There was very little public awareness about the new regime owing to the lack of a communication strategy, adversely affecting public support. - Since late 1998, the CNB has been very active in communicating its strategy to the public and specific interest groups, which has proven beneficial in gaining support for the new regime (Jonas and Mishkin, 2003). - The role of the government - The government was not involved in defining the new goal of price stability and setting inflation targets initially. - The new regime required a new interpretation of the law that until 2002 referred to currency stability. - Given the lack of agreement with the government, the CNB chose CPI net of administered prices to target inflation, which raised communication and statistical problems subsequently. - Since 2000, the government has been involved in quantifying inflation targets and has assumed responsibility for supporting the IT regime. - The CNB’s internal processes - Internal processes were not adequately equipped for the information and technical requirements of monetary policymaking under IT. - The CNB had very little capacity to forecast inflation with reasonable precision and analyze other macroeconomic developments. - Staff responsible for forecasting focused on information collection rather than undertaking analyses for monetary policy decision making. - The elements of a proper forecasting and policy analysis were put in place only by 2000 (C̆apek and others, 2003b). - The credibility of the new regime - The lack of supporting elements of the IT framework proved costly in establishing credibility. - The undershooting of the targets in the early years was associated with a protracted recession with rising unemployment, which endangered the independence of the CNB (see Jonas and Mishkin, 2003; and C̆apek and others, 2003a). - 12 Although the CNB’s independence was preserved, these pressures underpinned the importance of achieving the consent of the key parties (the government and the public in particular) in setting the inflation trajectory. - Footnote context: Whether or not high real interest rates were kept unduly long was not clear ex ante, particularly because there was a need to preserve credibility in the face of rising inflation. With the benefit of hindsight, a proper forecasting system could perhaps have allowed an earlier relaxation of the policy (C̆apek and others, 2003a). ### Lessons from the Czech experience - The Czech experience underscores the importance of maintaining consistency between the peg regime and the mix of macroeconomic policies under relatively open capital accounts in avoiding disorderly exits from a pegged exchange rate regime. - When policies are not in line with the peg, attempts to adjust the regime toward flexibility provide only a temporary relief and postpone an eventual adjustment. - Strengthening the banking system and developing financial markets and risk management instruments helped limit the severity of the disorderly exit and facilitated implementation of the new exchange rate regime and policy framework. - Adequate preparation for IT is crucial: public and government consent, effective communication, and necessary technical and organizational changes are needed to improve support for the new framework. - Even when conditions for successful IT implementation are not fully in place, the presence of a few key elements can help introduce the IT framework in a reasonably short period, thereby helping limit prolonged market instability. *Box 2. Czech Republic: The Condition of the Financial System — content as provided in the source PDF.* ### Appendix I From Fixed to Float: ### Appendix I From Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates ### Summary - This appendix summarizes the IMF’s operational framework for moving toward exchange rate flexibility for countries that have decided to adopt a more market-determined exchange rate.1 - The framework provides hands-on guidance on institutional, operational, and technical aspects of moving toward flexibility, drawing on the experience of countries that have managed the transition. ### Operational ingredients of durable exits from fixed to floating regimes - Although timing and priority vary by country, the successful ingredients for floating include:2 - Developing a deepandliquidforeignexchange (FX) market; - Formulating intervention policies consistent with the new exchange rate regime; - Establishing an alternative nominal anchor in the context of a new monetary policy framework and developing supportive markets; and - Reviewing exchange rate exposures and building the capacity of market participants, including the public sector, to manage exchange rate risks and of the supervisory authorities to regulate and monitor them. ### Developing a deep and liquid FX market - A flexible exchange rate regime works well only when there is a sufficiently liquid and efficient FX market for price discovery.3 - Key benefits of allowing exchange rate flexibility: - Improves depth and efficiency of the FX market and stimulates better risk management. - Creates incentives for market participants to gather information, form views, price foreign exchange, and manage exchange rate risks. - Establishes two-way risk perceptions that reduce one-way bets against the central bank. - Four key aspects of deepening the market and enhancing price discovery: 1. Reducing the central bank’s market-making role, including its quotation of buying and selling rates, and requiring market makers to provide two-way price quotations; 2. Increasing market information and transparency on the sources and uses of foreign exchange, detailed economic data, and a coherent policy framework; 3. Eliminating (or phasing out) regulations that stifle market activity;4 and 4. Improving the market’s microstructure, including by reducing market segmentation, improving the effectiveness of market intermediaries, and securing reliable and efficient settlement systems. - FX market structure note: - Wholesale interbank market: authorized dealers trade among themselves and where price discovery occurs. - Retail market: authorized dealers transact with final customers. ### A coherent FX intervention strategy - Under a flexible exchange rate regime intervention is discretionary; well-specified intervention principles are essential to enhance credibility. - Important dilemmas and considerations: - Potential disconnect between the exchange rate and macroeconomic fundamentals can create a role for intervention, but misalignments are difficult to detect and typical indicators may not allow precise pinpointing of amounts and timing.5 - Volatility reflecting market illiquidity may warrant intervention to jump-start the market or reverse a perverse price trend, but short-term volatility in an orderly (liquid) market often reflects price discovery and may not warrant intervention. - Exercising restraint during the transition can signal commitment to a market-determined exchange rate; interventions targeting a level or path can undermine credibility. - Even in fully flexible regimes, regular interventions (for reserve management or to supply foreign currency revenue to the market) may be appropriate and can be regular, preannounced, and rule-based (for example, through auctions) to enhance information flow and signaling. - Transition needs a coherent intervention strategy specifying objectives, timing, and amounts; transparency and public commitment to intervention objectives and criteria are important for market scrutiny and accountability. ### Developing an alternative nominal anchor under a new monetary policy framework - Moving away from a fixed exchange rate requires replacing it with a credible nominal anchor and redesigning the monetary policy framework around that anchor. - Credible alternatives (notably inflation targeting (IT)) require extensive preparation and capacity/credibility building; many countries favored IT frameworks over money-targeting ones. - Institutional and macroeconomic preconditions for IT include: 1. A central bank mandate to pursue an explicit, publicly announced inflation target as the overriding objective of monetary policy; 2. Central bank operational independence; 3. Transparency and accountability in the conduct and evaluation of monetary policy actions; 4. A reliable methodology for forecasting inflation and its link with other macroeconomic aggregates; 5. A forward-looking operating procedure that systematically incorporates forecasts into policy actions and responds to deviations from targets; 6. Lack of fiscal dominance; and 7. A well-regulated and supervised financial sector. - Practical approaches when IT preconditions are not yet met: - Some countries relinquished the exchange rate anchor gradually or used monetary-targeting approaches (base money, broad monetary aggregates, or bank reserves) temporarily. - Crawling bands have been used as an intermediate regime, set symmetrically around a crawling central parity and gradually widened over time. ### Capacity to assess and manage FX risks - Floating moves exchange rate exposure from public to private sector balance sheets; determining the scale and scope of FX risk exposures in financial and nonfinancial sectors is key. - Evaluating exchange rate risk exposures requires detailed balance sheet analysis focusing on: - Currency composition of balance sheets; - Maturity, liquidity, and quality of foreign currency assets and liabilities. - Key risk channels and concerns: - Unhedged FX corporate borrowing can translate into massive bank losses and surges in demand for foreign currency. - Even matched FX assets and liabilities in banks can create indirect FX risks when short-term FX funds finance long-term FX loans to unhedged borrowers. - Maturity mismatches in banks’ foreign currency books create foreign currency liquidity risks. - Corporate and banking sector exposure to interest rate risk can limit the central bank’s ability to use interest rates instead of FX interventions. - Required market and supervisory capacity: - Market participants need information systems, analytical systems for risk measurement, and internal risk and prudential procedures. - Adequate prudential and supervisory arrangements: limits on net open positions (as a percentage of capital), foreign currency lending (as a percentage of foreign currency liabilities), overseas borrowing and bond issuance (as a percentage of capital); limits on FX operations banks can perform; capital requirements against FX lending or risk; issuance of regulations/guidelines on banks’ internal control systems. - Improve capacity to enforce regulations and develop risk-based supervisory systems. - On derivatives and forward markets: - Carefully developed derivatives markets are essential to build FX risk management capacity. - Liberalizing forward transactions can improve risk management but may also facilitate speculative activity. - Safe use of derivatives requires financial institutions and corporations with sufficient sophistication, supervisory authorities capable of risk-based supervision, close monitoring to prevent leveraged bets, standardization of derivative products, accounting standards for fair valuation, and a reliable legal system for contract enforcement. - The central bank should promote market transparency and, with other regulators, promote high reporting standards. - Basel guidance: - The Basel Committee recommends a capital charge of 8 percent on the open position based on the shorthand method and recommends that the net open position does not exceed 2 percent of capital, although countries with greater risk exposures may need to adopt more conservative limits.7 - All open position calculations should include net spot and forward positions, guarantees, and net future income and expenses not yet accrued, but already fully hedged. ### Pace and sequencing of exit to exchange rate flexibility - Pace and sequencing involve trade-offs depending on country-specific factors: preparedness for floating, capital account openness, macroeconomic situation, and market conditions. - Broad conclusions: - From a position of macroeconomic strength, a faster pace of exit has benefits: signals purpose and determination, enhances monetary policy credibility, and may exploit a narrow window of tranquility if institutional underpinnings are in place. - The pace at which institutions (an alternative nominal anchor and risk-management capacity) can be built largely determines how quickly an orderly exit can proceed; many countries opt for a gradual approach to reduce the risk of excessive exchange rate volatility and its potential adverse effects on inflationary expectations. - Stages of transition (as presented in Figure A1): - Stage 1: Fixed peg - Stage 2: Limited exchange rate flexibility - Stage 3: Significant exchange rate flexibility - Stage 4: Float - Groundwork activities across stages include: preparing for inflation targeting/alternative nominal anchor; building up exchange rate risk management and regulation; development of foreign exchange market; formulating intervention policies; culminating in full-fledged inflation targeting. *Appendix I — From Fixed to Float: Operational Ingredients of Durable Exits to Flexible Exchange Rates.* ### Appendix I ### Appendix I ### Stages toward greater exchange rate flexibility - Allowing limited exchange rate flexibility can deepen the FX market through a mutually reinforcing relationship between FX activity and exchange rate flexibility and provides time to build remaining institutional blocks. - Early preparation for an exchange rate float can bolster the chances of success of the exit strategy—gradual or rapid. - Many operational areas require substantial information on exposures to and capacity to manage FX risk, and increasing data on balance of payments developments. - These preparatory steps can be undertaken early on, even before a peg is exited. - The second stage may involve allowing some exchange rate flexibility to stimulate FX market activity and continuing to develop other operational areas. - Intervention policies can be addressed at a relatively later stage, once greater exchange rate flexibility is embraced. - The text references a suggestive illustration of various stages toward moving to full flexibility (see Appendix Figure A1). ### Institutional foundations and monetary policy frameworks - The absence of a full-fledged IT framework as an alternative nominal anchor should not preclude a rapid exit strategy, provided that there is a robust commitment to price stability. - The building blocks of IT—such as fiscal discipline, operational independence of the monetary authorities to pursue low inflation, and transparency and accountability—are necessary for the success of any monetary policy regime regardless of a formal adoption of IT. ### Capital account openness, sequencing, and trade-offs - The pace of exit needs to take into account the openness of the capital account. - It may be difficult to pursue a gradual exit strategy under conditions characterized by large and volatile capital flows. - By contrast, a less open capital account would make it easier to operate variants of pegs or manage the exchange rate within a band. - Clear trade-offs are involved in the sequencing of exchange rate flexibility and capital account liberalization. - There are risks to opening the capital account before adopting a flexible exchange rate: - Many countries were forced off pegs after sudden reversals of capital flows. - Others faced heavy inflows and appreciation pressures and had to allow flexibility to avoid overheating. - Potential benefits of liberalizing the capital account: - Liberalizing the capital account can help offset transitory current account shocks, expand the instruments for risk management, and deepen the FX market, which is important for operating a flexible exchange rate. - The transition to flexibility can be facilitated by removing or strengthening existing asymmetries in the openness of the capital account to support an orderly correction of misalignments (for example, by liberalizing outflows to reduce pressures from inflows, and liberalizing long-term inflows before short-term ones). - Remaining controls can be removed following a successful move to floating. ### Operational considerations and sequencing recommendations - Many operational areas require: - Substantial information on exposures to FX risk. - Capacity to manage FX risk. - Increasing data on balance of payments developments. - These operational preparations can and should begin before exit from a peg. - Intervention policy design can be postponed until after an initial embrace of greater exchange rate flexibility. - A robust commitment to price stability and the underlying building blocks of IT are critical enablers for either gradual or rapid exit strategies. *Source: Appendix I* ### Appendix IV ### Appendix IV ### Central bank role in hedging markets - Tax, accounting, and regulatory barriers that increase the cost of hedging should be addressed and tax discrimination eliminated. - Accounting standards should provide for appropriate treatment of hedging transactions. - The central bank can increase awareness and hedging skills among users, accountants, and auditors. - The central bank can support professional groups (ACI), the setting of standards (CFA), market codes of conduct, and adoption of master agreements and standard documentation (ISDA). - The central bank could consider providing objective benchmarks and pricing mechanisms, such as FX and interest rate fixings, but should play a statistical role only, leaving markets to determine rates. - Foreign entities and other financial intermediaries, such as nonbank market makers and brokers, should be allowed to contribute to market development. - Market infrastructure and institutions needed: - Efficient payment and clearing systems with payment versus payment and delivery versus payment. - Availability of reliable financial data and information. - Market surveillance by the central bank can be helpful, especially in early development stages—even where it is not the primary regulator. ### Complementary financial markets - FX market development depends on other financial markets; lack of development in one market can retard others. - Well-developed markets reinforce one another, promoting efficiency and continued development. - Short-term money markets have the closest link to FX markets; interbank loan and deposit liquidity is essential for interest rate parity and for developing forward and swap transactions. - Within the FX market, foreign exchange versus foreign exchange transactions and derivative markets (forwards, swaps, futures, options) are important risk management tools; forward and swap transactions usually develop with spot FX and money markets, while long-dated swaps, futures, and options come later. - Fixed-income markets, especially government bond markets, provide benchmarks; absence of a well-developed liquid securities market undermines pricing of swaps, forwards, and other hedging instruments. - A developed capital market complements banking markets, broadens assets, diversifies financing channels, and improves operational efficiency. - Central bank actions to promote complementary markets: - Eliminate unnecessary obstacles (e.g., restrictions on instruments or techniques such as short sales). - Reduce excessive licensing, reporting, or regulatory burdens. - Help establish strong bank supervisory capability through coordination with other authorities, including capital market and securities regulators and organized exchanges. - Reduce or eliminate institutional segmentation by product or customer. - Clarify legal issues (treatment of collateral and repurchase (repo) transactions). - Promote an efficient and transparent tax regime and eliminate tax discrimination. - Support clear and modern accounting and reporting standards. - Support establishment of efficient organized or OTC markets, including brokers and intermediaries. - Technical standardization needs: - Day-count, computation, and payment methods for money and fixed income markets. - Information systems and availability of indices and reliable benchmarks. - Compatibility with international standards and accepted market practices where possible. ### Case study: The Bank of Israel’s interventions (Box A1) - Context: - Prior to 1989, a history of managed exchange rates in Israel led to limited practice of hedging domestic currency fluctuations. - In early 1989 Israel adopted a horizontal band allowing limited foreign exchange rate flexibility (±3 percent), replacing a fixed peg with periodic devaluations. - FX options initiative: - In 1989 the BoI began selling call options on the U.S. dollar by auction to commercial banks only (legal restrictions prevented direct dealing with the public). - Amount issued was set at $24 million per week and never increased. - Issuance policy changes: put options and six-month maturities were added to the original three-month contracts. - Market timeline and outcomes: - An OTC market began in 1990. - In 1994 the Tel Aviv Stock Exchange began trading options contracts (in 2002 it added NIS/euro contracts). - In 1996 volume in both the OTC and the Stock Exchange increased rapidly. - By 2004, BoI options accounted for less than 3 percent of outstanding options and less than 0.5 percent of turnover. - In 2005 the BoI ceased issuing three-month foreign exchange options but continued issuing six-month contracts; stopping issuance had no noticeable effect on options trading. - Assessment: BoI’s role acted as a catalyst in developing the FX options market, accelerated market appearance, provided data and information on exchange rate developments and expectations, and did not prevent private sector development. - Interest rate hedging initiative: - By 1990 BoI shifted monetary policy focus to interest rates and began to auction three-month future contracts based on 3- and 12-month treasury bills to spur interest rate hedging. - Outcomes and statistics: - Interest rate hedging markets developed much more slowly and remained fairly small and illiquid. - OTC trading of interest rate forwards developed sporadically; exchange-traded contracts introduced in 2000 were discontinued shortly thereafter owing to low trading volumes. - In 2004 total outstanding OTC interest rate derivatives reached NIS 4 billion, compared with NIS 160 billion for foreign exchange derivatives. - Internationally, interest rate derivatives comprise 80 percent of outstanding derivatives positions, versus the 14 percent share of foreign exchange derivatives in Israel’s case. - Factors cited for weak interest rate hedging development: - Historical reliance on consumer price indexation and real interest rate denominated contracts rather than nominal interest rate instruments. - Shorter history of interest rate volatility. - Government debt issuance policy not always helpful. - Underlying market illiquid, fragmented, and incomplete. - Administrative obstacles: no short selling or security lending and no market makers (plans for government bond market makers to begin operations in 2006). - Lack of clear enforceability of netting and collateral arrangements. ### Considerations for a direct central bank role in market development - Potential rationales for an active central bank role: - Possibility of market failure (multiple equilibria, inertia, collusion, coordination failures). - Relative advantage of the central bank and role as catalyst in a development cycle. - Central bank may already bear risks and costs that tradable instruments would make more transparent. - Risks and arguments against direct central bank involvement: - Not a core central bank role and may crowd out private sector or introduce distortions and inefficiencies. - Risk of failure with implications for central bank reputation and credibility. - Adds financial and operational risks requiring scarce resource management; failures could be costly. - Guidelines if central bank chooses to act directly: - Carefully define and limit goals; delineate and circumscribe the role from the outset. - Establish milestones to prevent a self-perpetuating central bank role. - Periodically evaluate market development and costs and/or profitability of central bank involvement. - Limit safety nets in extent and duration; make costs and incentives explicit and tied to obligations. - Prepare and strictly adhere to an exit strategy. ### Summary of main points - FX risk hedging should be encouraged to improve pricing and managing of risk, increase stability at all levels, and improve welfare. To achieve these goals: - FX variability should be allowed to increase. - Regulatory and other obstacles to hedging should be removed. - An appropriate environment should be provided. - Development of complementary financial markets is essential to FX market development and brings additional benefits: - Greater efficiency, completeness, improved monetary policy transmission, competition, diversification, and operational efficiency. - The central bank can: - Promote an appropriate environment. - Assist in establishing necessary conditions and infrastructure. - Take initiatives to help develop FX hedging and complementary markets. - A direct central bank role can be beneficial in certain cases, but the costs and risks should be carefully considered. *Appendix IV* ### Bibliography ### Bibliography ### Topics covered in cited literature - “The Development of the Currency Derivatives Market in Chile” - “A Balance Sheet Approach to Financial Crisis” - Capital Controls: Country Experiences with Their Use and Liberalization - “Capital Account Liberalization, Capital Flow Patterns, and Policy Responses in the EU’s New Member States” - “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004” - Annual Reports and departmental reports of central banks (e.g., Bank of Israel; Central Bank of Chile) - Amendment to the Capital Accord to Incorporate Market Risks - Exchange rate policy, inflation targeting, and monetary policy strategy in transition and emerging market economies (multiple country experiences) - “Exchange Rate Exposure” - “Establishing Initial Conditions in Support of Inflation Targeting” - Operational aspects of moving toward exchange rate flexibility (“From Fixed to Float”) - Capital Account Liberalization and Financial Sector Stability - Measuring liquidity in financial markets - Foreign exchange market intervention: motives, techniques, and implications - Financial dollarization and crisis management in dollarized economies - Methods for developing consistent scenarios with forecasting and policy analysis systems - “Hedging Foreign Exchange Risk in Chile: Markets and Instruments” ### Representative country-focused citations (exact titles and country references preserved) - Chile: “The Development of the Currency Derivatives Market in Chile”; Central Bank of Chile, Annual Report; “Hedging Foreign Exchange Risk in Chile: Markets and Instruments”; “La Política Cambiaria”; “Overcoming Fear of Floating: Exchange Rate Policies in Chile”; “Exchange Rate Policy in Chile: From the Band to Floating and Beyond”; “Effects of Foreign Exchange Intervention Under Public Information: The Chilean Case” - Israel: “The Inflation Target in Israel: Policy and Development”; “Inflation and Disinflation in Israel”; “Liberalization of the Foreign Exchange Market in Israel 1950–2002”; “Principle Stages in the Liberalization of Control on Foreign Exchange in Israel 1987–January 2003”; “Israel’s Financial Account Liberalization” - Uruguay: “Política cambiaria y objetivos de inflación en Uruguay”; “Uruguayan 2002 Financial Crisis Resolution at a Glance”; “To Hell and Back: Crisis Management in a Dollarized Economy: The Case of Uruguay” - Czech Republic and Poland: “Pegging Out: Lessons from the Czech Exchange Rate Crisis”; Czech National Bank’s Forecasting and Policy Analysis System; “Forex Interventions: The Czech Experience”; “Financial Inflows to Poland, 1990–96”; “Capital Account Liberalization in Poland” - Brazil, Mexico, and other emerging markets: “Inflation Targeting in Emerging Market Economies”; “Capital Flows and Controls in Brazil: What Have We Learned?”; “Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate” ### Methodologies, frameworks, and analytical approaches referenced - Balance sheet approach to financial crisis - Forecasting and Policy Analysis System (FPAS) development and historical perspectives - Operational guidance on moving from fixed to flexible exchange rate regimes - Measuring liquidity in financial markets - Financial soundness indicators and analytical aspects - Case-based analysis of banking crises and capital liberalization episodes - Use of working papers, IMF Occasional Papers, BIS Papers, and central bank studies as primary analytical vehicles ### Recurring policy themes and areas of analysis drawn from cited works - Exchange rate regimes and transition strategies to greater flexibility - Design and implementation of inflation targeting in emerging and transition economies - Capital account liberalization, sequencing, and implications for financial stability - Foreign exchange intervention techniques and sterilization operations - Crisis management in dollarized or highly dollarized economies - Role of central bank reporting and communication in supporting policy transitions - Prudential regulation in foreign exchange and capital account liberalization contexts *Source: _op256 - Bibliography* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/op/256/_op256.pdf_