December 30, 2004
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On December 13, 2004, the Executive Board of the International Monetary Fund (IMF) considered an IMF staff paper "From Fixed to Float: Operational Aspects of Moving Toward Exchange Rate Flexibility", which provides operational and technical guidance for countries that have decided to move toward a more flexible exchange rate regime.
Background
In recent years, a number of countries have moved towards more flexible exchange rate regimes. Most of these exits have occurred under disorderly conditions, but some transitions have been relatively gradual and smooth.1 Independent of whether it is an orderly or disorderly exit, these moves are complex from an institutional and operational perspective. Accordingly, the Board has urged staff to provide more advice to countries to aid in the transition.2
To provide more guidance, the IMF staff prepared a paper for a Board seminar. It provides hands-on guidance to countries that have decided to move towards a more market-determined exchange rate, drawing on the experience of countries that have managed the transition.
For a successful transition to flotation the paper identifies the following four ingredients to be generally needed: (i) a deep and liquid foreign exchange market; (ii) a coherent intervention policy; (iii) an appropriate alternative nominal anchor; and (iv) adequate systems to review and manage public and private sector exchange rate risk. Finally, the paper deals with the pace of exit and sequencing especially in relation to the liberalization of the capital account.
Executive Board Assessment
Directors appreciated the opportunity to discuss the staff's findings and recommendations on operational steps to support greater exchange rate flexibility for countries that have decided to move toward a more market-determined exchange rate. Directors recalled that, at the 2004 biennial review of surveillance, they had underscored the need to assist countries that are contemplating a move toward greater exchange rate flexibility, and considered the staff paper a helpful contribution to this effort. The reflection on experiences of those countries that have made the transition was considered particularly useful.
At the same time, Directors reaffirmed that no single exchange rate regime is appropriate for all countries in all circumstances. They underscored that the paper should not be regarded as a prescription that floating is the preferred option, noting that the Executive Board has not asserted the superiority of any one exchange rate regime over another. In this regard, some Directors felt that the paper could have discussed the rationale for moving to a flexible exchange rate regime and the conditions under which such a move would or would not be appropriate.
Directors agreed with the broad thrust of the paper, notably that the following four ingredients will generally support a successful, orderly transition to a float: (i) a deep and liquid foreign exchange market; (ii) a coherent intervention policy; (iii) an appropriate alternative nominal anchor; and (iv) adequate systems to review and manage public and private sector exchange rate risk. Directors acknowledged that these four factors constitute an ideal framework only, noting that the experience of some countries that have successfully floated the exchange rate shows that every ingredient does not necessarily need to be fully met before moving to greater flexibility. At the same time, some Directors emphasized that the costs of delaying the transition to a float in order to meet all of the four ingredients should be carefully weighed against the benefits of introducing more flexibility at an early stage. In this context, Directors felt that more guidance on the sequencing and order of importance of these conditions would have been useful, backed by analysis of more specific country experiences and cross-country studies. They looked forward to further elaboration on these aspects in the context of Article IV consultation or program discussions. Furthermore, Directors emphasized that prudent policies, a stable macroeconomic environment, and an effective communications strategy are key elements to help support an orderly move to greater exchange rate flexibility, and indeed for the success of any exchange rate regime. Some Directors noted that under such conditions there may be less incentive to move from a fixed to a flexible exchange rate regime.
In reviewing the key aspects of developing a deep and liquid foreign exchange market, Directors highlighted the need to reduce the central bank's market-making role, increase information flows in the market, and improve the market microstructure. In addition, they underscored the need to foster two-way risk in the foreign exchange market to help develop risk management expertise and minimize destabilizing trading strategies. The view was also held that many countries have managed to develop centralized and efficient markets that are responsive to supply and demand forces and provide good price signals, without having a complete domestic regulatory and institutional structure in place.
In discussing intervention strategies and modalities of the exchange rate regime, Directors recognized the potential tensions between legitimate reasons for intervention and the difficulties in identifying the conditions for, and determining the appropriate timing of, intervention. They noted that identifying and correcting exchange rate misalignments are difficult in practice, and that exchange rate movements may provide important market signals. In light of the difficulties in conducting intervention, many Directors underscored the need to review carefully the intervention policies to be implemented in the transition to floating. In particular, they cautioned that intervention should not be used as a substitute for implementing prudent policies and structural reforms. Some Directors underscored that intervention can serve a useful purpose during transition and also under a flexible exchange rate regime more generally, as a way to limit inflation arising from the pass-through impact of currency depreciation and to smooth disorderly markets.
Directors agreed that inflation targeting can be a useful and transparent nominal anchor over the medium term for countries that are floating. They cautioned, however, that many countries lack the institutional prerequisites to implement inflation targeting quickly and successfully. Furthermore, Directors stressed that other nominal anchors can also be used to promote credible anti-inflationary monetary policies that, combined with sound fiscal policies, can provide a solid environment for flexible exchange rate regimes. Indeed, it was noted that many advanced countries that have floating exchange rates have not adopted inflation targeting, and that money targeting can be a viable nominal anchor in its own right, not just as a transition to inflation targeting. Directors encouraged countries to move forward with core institutional reforms that are helpful for both inflation targeting and alternative anchors, such as the promotion of independent central banks.
In discussing systems to manage foreign exchange regimes, Directors recognized that floating transfers some risks back to the private sector, and could bring some vulnerabilities to the fore. In this regard, they encouraged countries to strengthen, at an early stage, systems to manage foreign exchange risk in the private sector. They also encouraged the use of such systems for the public sector in light of its exposure to exchange rate risk. Directors regarded such systems as generally beneficial, as they can also ensure greater sustainability of pegged exchange rates by limiting quasi-fiscal liabilities. Directors stressed that strong bank supervision can help mitigate the direct risks from open exposures in the financial sector. In this regard, Directors highlighted that the Fund could leverage its know-how in the adoption of prudential standards, and suggested that more practical advice be given to countries in this area. A few Directors also mentioned that more consideration should be given to the monitoring of hedge funds flows and suggested that a global information system be further developed.
Directors agreed that the pace at which relevant institutions can be built is a main determinant of how early preparations for an exchange rate float can be useful to bolster the ability to exploit opportunities to move in an orderly manner. In this vein, several Directors encouraged a fast pace of exit to bolster the credibility of monetary and other policies necessary to support an orderly exit. Many other Directors, however, recommended a gradual move to exchange rate flexibility to preserve the benefits of exchange rate stability, while gradually achieving the gains associated with flexibility, such as allowing greater capital mobility.
Most Directors agreed that experience highlighted the risks of opening capital accounts before floating the exchange rate, and especially the risk of sudden outflows. In light of this experience, they supported moving toward increasing flexibility ahead of or at the same pace of liberalizing the capital account, while recognizing that this advice depends on country circumstances. The point was, however, also made that capital account liberalization should be seen as beneficial on its own merits. Directors noted that the order of liberalization can help ensure a smooth transition to a float. They agreed that the order needs to be calibrated based, among other things, on the state of the financial sector and on the need to create two-way risk in the exchange market and avoid large overshoots.
The seminar has been a useful step toward developing the practical advice that the Fund can offer to members who wish to undertake the transition toward more flexible exchange rate arrangements. Nevertheless, Directors recognized that more can be done to support countries' efforts in a variety of circumstances. First, Directors encouraged the staff to continue to be ready to provide technical assistance, if necessary at very short notice. Second, Directors encouraged follow-up work in the following specific areas: (i) developing and refining the operational advice as to the speed and sequencing of the move toward floating, including more quantitative guidance, with a specific focus on practical problems in individual countries or groups of countries; (ii) drawing lessons from disorderly exits about measures that can be put in place rapidly and successfully; (iii) drawing additional lessons on the factors that make orderly exits, of both the gradual and rapid variety, durable; and (iv) defining further the elements of an adequate risk management system. Some Directors requested that more work be done to support moves toward greater exchange rate stability, notably for countries joining regional exchange rate arrangements.
