Transcript

Friday, April 14, 2000

[Partial Transcript]

PANEL:

MICHAEL MUSSA
IMF Economic Counselor and
Director, IMF Research Department

GRAHAM HACCHE
Deputy Director
IMF External Relations Department

PAUL ROBERT MASSON
Senior Advisor
IMF Research Department

ALEXANDER SWOBODA
Senior Policy Advisor
IMF Research Department

P R E S S B R I E F I N G

MICHAEL MUSSA

MR. HACCHE: Good morning, ladies and gentlemen. Welcome to this press briefing on "Exchange Rate Regimes in an Increasingly Integrated World Economy." My name is Graham Hacche. I am Deputy Director of the External Relations Department of the International Monetary Fund (IMF).

This study on exchange rate regimes, an issue that is, of course, central to the IMF's mandate, has been undertaken by a team in the Research Department led by Michael Mussa, who heads the Research Department and is also the IMF's Economic Counselor.

The background to this study is the renewed interest in the issue of appropriated exchange rate arrangements, prompted by the currency and payments crises of the 1990s; the general increase in capital mobility and the boom-bust character that we sometimes see involving capital flows to developing countries.

This paper also responds specifically to a request from the IMF's Interim Committee a year ago that the Fund's Executive Board should consider further the issue of appropriate exchange rate arrangements, including in the context of large-scale official financing. Michael Mussa will talk more about the background and conclusions of this study in a moment.

Before turning to him, let me introduce the other members of today's panel: Alexander Swoboda, who is Senior Policy Advisor in the Research Department, and Paul Masson, a Senior Advisor in the Research Department, who is currently on sabbatical at Georgetown University and the Brookings Institution in Washington.

Now, let me turn to Michael Mussa.

MR. MUSSA: Thank you very much, Graham. I am going to speak only very briefly this morning and then turn the microphone over to my two colleagues, who are the principal supervisors of the two main sections of this report.

First, let me just say a couple of general words about the report and its analysis. We were asked by the Fund's Interim Committee, now the International Monetary and Financial Committee, to reexamine the issue of exchange regimes in light of important changes that have been taking place in the world economy; in particular, the increase in international capital mobility and the increase in participation of many developing countries, or so-called emerging market countries, in the international financial system.

We took our task to be a comprehensive one. The IMF is a virtually universal organization. We have 182 members, and we wanted to look at the issue of exchange regimes across the entire membership, from the largest industrial countries, whose national currencies form the main foundation of the international monetary and financial system, to the smallest members of the IMF.

Not surprisingly, when one examines such a wide range of countries at varying levels of development, with varying degrees of financial sophistication, one does not reach a uniform conclusion about the most appropriate exchange rate regime to apply universally to all of those countries. And perhaps the single most important conclusion of our analysis is that there is no single exchange rate regime that is best for all countries, at all times, in all circumstances.

However, more than that can be said. There are certain types of exchange rate regimes that do seem better suited to some countries, in some circumstances, at some times. So it is not that anything goes, or that the same thing goes for everybody in exactly the same way.

With that very broad statement, let me turn, first, to my colleague, Alexander Swoboda, who will talk briefly about our analysis of exchange rate regimes for the industrial countries, and then to Paul Masson.

MR. SWOBODA: Well, certainly, the world in which we live is a different one from the world that we saw when the IMF was created at Bretton Woods, and one of the distinguishing characteristics is the invigoration of certainly the advanced countries into the world financial and monetary system, and increasingly that of developing countries.

A new phase in the evolution of the post-war international financial system and exchange rate system can be dated to the launching of the euro in January 1999. So I would like to comment briefly on the relationship between the system's key currencies, the dollar, the yen and now the euro. Let me confine myself to comments on two questions that we raise in the paper and add two remarks.

The first question concerns the evolution of the relations between the euro and other currencies—the dollar, in particular. Can we expect to see in the future the type of volatility and the large medium-term swings in exchange rates that we have seen in the past, notably between the deutschemark and the dollar?

We answer in the affirmative for the near future, at least for volatility. And we base this answer, both on an analysis of the past behavior of exchange rates — notably that of the behavior of a synthetic euro — an index we have constructed on the basis of the current composition of the euro area, and on the basis of its straight patterns.

No systematic trends can be discerned in the evolution of the volatility of exchange rates if one divides the past two decades or so into sub-periods of equal length. If you pick and choose, you can find periods where the volatility seems to be higher, others where it seems to be lower. But if you don't approach your question with a preconception as to the sub-periods you are analyzing, you cannot do so.

On the other hand, if we consider the fact that the euro area as a whole is a more closed economy than its components, together with a clear mandate of the European Central Bank (ECB) to a monetary policy focused on inflation, rather than the exchange rate, we again have to conclude that volatility is likely to be quite high in the future, as it has been in the past.

That leads me to the second question, which is what are the medium-run prospects for more active management of the major currency exchange rates? Here, proposals have ranged from the World Central Bank, at one end of the spectrum, to absolute, pure and clean floating at the other extreme, with some form of target zone somewhere in the middle.

Our prediction is that the relations between the three major currencies will be much closer to the pure float end of the spectrum. There is just not enough political commitment to stabilize exchange rates in a narrow range in a world of high capital mobility between major currency areas, a message that harks back to one of the main themes of our paper.

We do not see the Federal Reserve or the ECB sacrificing domestic objectives for the pursuit of exchange rate stabilization. That being said, we also believe that major prolonged misalignments of the major exchange rates are a cause of serious concern both for the major countries themselves and for the rest of the world. Here, we see a role for IMF surveillance for some of the methods that are being developed for concerted action on the part of the G-3 or G-7 to avoid the most severe forms of imbalances.

Now for a remark about this. Is the conclusion that I just alluded to — benign neglect — except in cases of gross misalignments, such a bad thing? Would it not be better to give much of your weight to exchange rate stabilization in the monetary policies of the ECB, the U.S. Federal Reserve and the Bank of Japan? I think not. There is a trade-off here between stabilizing the exchange rate and stabilizing the domestic economy, the price level and output in the three major areas.

Would we want the ECB to tighten its monetary policy today and the Fed to loosen its monetary policy in order to reappreciate the euro? We don't think so. All the more so that there doesn't seem to be a gross misalignment between these currencies, but a change due to different points in the business cycles for the two areas.

Last remark: Once again, that does not mean that the erratic behavior of the major exchange rates need not be a cause for concern, in particular for the smaller and developing economies that must take those exchange rate changes as given. This is a matter on which Paul Masson will undoubtedly have something to say, as well as some of the other lessons that can be learned from some of the smaller industrialized countries' experience in the past 10 or 15 years, which we talk about at, too, greater length in the paper.

MR. MASSON: I think that one of the important realities, as Alexander Swoboda has mentioned, is that developing countries' choice of exchange rate regimes has to be conditioned to the international environment, and that's an international environment among the major currencies that we see as continuing a substantial degree of flexibility.

However, the individual circumstances of each developing country will also have an influence on their choice of exchange rate regime. And there is a wide variety of circumstances facing individual countries that leads them to a wide range of choices of exchange rate regimes, going from a substantial degree of exchange rate flexibility, though perhaps not a completely free float, to, at the other extreme, a currency board or monetary union.

In the middle range, we see crawling bands, adjustable pegs, various forms of exchange rate regimes that are characterized neither by substantial flexibility on a day-to-day basis, nor by a commitment to a fixed and unchanging peg. And some have argued that this middle range of regimes is likely to disappear because it is unsustainable, especially for those countries facing substantial integration to international capital markets.

In the paper, we acknowledge that this tendency to greater capital market integration makes the requirements for sustaining exchange rate regimes that are not at either extreme somewhat more demanding. It also makes maintaining a successful and stable floating regime, or continuing with a strong commitment to a fixed peg, more demanding in terms of the policy requirements.

There has been some tendency toward increased flexibility if we look at the classification of exchange rate regimes for developing countries. We do, however, expect that there will continue to be a range of regimes in the future, as there is today.

Some of the considerations that will influence the choice of exchange ate regime include, for instance, the degree of diversification of trade, where the flexibility among the major currencies will cause some problems for single currency pegs, given that pegging to one of the major currencies will imply substantial fluctuations relative to the other.

Single currency pegs, however, are at present, and will no doubt continue to be, very valuable and desirable regimes for countries with a strong concentration of trade with one of the major blocks. In fact, a large proportion of IMF members do have single-currency pegs.

For countries moving to greater exchange rate flexibility, the alternative to the exchange rate as a nominal anchor needs to be developed, institutions need to be developed to provide that alternative anchor. We did have some discussion in the paper of what that might consist of, whether monetary aggregate targeting or inflation targeting.

For those countries moving to greater flexibility, it's unlikely that benign neglect of the exchange rate, that is, a perfectly free float, is going to be desirable. What one needs to have is deep foreign exchange markets, and typically, developing countries do not have that. So some degree of intervention and concern in setting monetary policy for movements in the exchange rate, some degree of concern is likely to persist.

Thank you.

MR. HACCHE: First question.

QUESTION: What are the lessons learned from the experience of Argentina and the pegging of the currency there in relationship with what happened in Brazil? And also I would like a comment on the devaluation process in Ecuador. Is the IMF supporting it 100%?

MR. MUSSA: The Executive Board has not yet passed on the program. So it is probably premature to say the Fund is supporting it 100%. But I anticipate that the Executive Board will vote approval of the program, and at that point we will be able to say the Fund, which does mean the decision of the Executive Board, is supporting it 100%.

In terms of the experience with both Brazil and Argentina, they both illustrate, I think, a general phenomenon that has been of great importance in terms of dealing with problems of stabilizing economies that have histories of rapid inflation. This was certainly true in Brazil before the Real Plan in 1994. Between 1970 and the start of the Real Plan, Brazil added 12 zeroes to the price level—so an average annual inflation rate of about 400% per year, year-in and year-out. And Argentina, before the Convertibility Plan in 1990, had extremely rapid inflation, several bouts of hyperinflation.

Often for countries with that problem, a useful way to bring about a rapid reduction of inflation, without having large, harmful costs in terms of output, is by going for what we call an exchange rate-based stabilization, which the Real Plan was and which the Convertibility Plan was in an even more extreme form, if I may put it that way. Both of those efforts were very successful in bringing inflation down very rapidly, with very limited costs in terms of output growth.

In the case of Argentina, the Convertibility Plan has proved highly doable, notwithstanding the pressures that were felt at the time of the Tequila Crisis in 1995 and the associated recession in Argentina as they defended the Convertibility Plan by raising interest rates and tightening fiscal policy.

The Argentine economy, in the decade of the 1990s, has performed significantly better than Argentina performed in the 1950s, '60s, '70s or '80s. That is absolutely true in terms of inflation, and it's also true in terms of real output growth. This is not to say that there have not been difficulties—the recession of '95 and the recession of '99—that are at least in part associated with policies that have been necessary to defend the exchange rate peg.

Brazil's peg came under pressure first in 1997, at the time of the start of the Asian Crisis in October, and the Brazilians tightened monetary policy very significantly, pushing short-term interest rates up to 40%. Those actions, together with some adjustments in fiscal policy, but in the end, inadequate adjustments, did hold the Real Plan on its slowly depreciating path through 1998. However, as one would expect in these circumstances, the Brazilian economy did experience a fairly severe recession in 1998 and early 1999.

Ultimately, in the case of Brazil, defense of the Real Plan proved not sustainable, in our judgment, because inadequate adjustments of fiscal policy had been pursued by the Brazilian Government. It was then necessary to exit from the pegged exchange rate regime and move to a floating exchange rate regime.

That regime has actually proved quite successful. It's proved quite successful, I think in part, because the Brazilians did enact the necessary adjustments in their fiscal policy, which was a fundamental source of their difficulties. When the new Central Bank Governor came in, he undertook a sufficient near-term tightening of monetary policy to provide assurance that the exchange rate would not be allowed to depreciate without limit.

So the Real Plan was successful in bringing inflation down in the first instance, and in the end, a relatively successful effort from that exchange rate peg was achieved in early 1999. Now, of course, Brazil and Argentina have significantly different exchange rate policies. Argentina continues with the very strong peg, whereas Brazil continues to float with the exchange rate moving up and down in response to market forces.

This is, I think, what we can expect to be the case for a number of emerging market countries. As I mentioned in my opening remarks, it is not a one-size-fits-all exchange rate regime prescription. For a variety of historical reasons, Argentina has a very hard peg, and they have the policies that are necessary to sustain that peg, in terms of their monetary and fiscal policies, and in terms of maintaining a very well-capitalized, very well-regulated, very solid banking system.

Brazil did not have quite the necessary combination of supportive policies to sustain the Real Plan, and they needed to exit, ultimately, to a floating rate.

MR. HACCHE: Next question.

QUESTION: First of all, I wanted to clarify whether I understood you to say that at this point there doesn't seem to be any gross misalignment among the three major currencies?

MR. SWOBODA: I only referred to two of them. I didn't refer to the yen. But that being said, I think in the case of the yen, there might be some misalignment, although at the present it's not so bad, and it shouldn't get worse, in cyclical terms. Domestic considerations point in the same direction; namely, letting monetary policy still be supportive of Japanese recovery and not tightening at the moment.

QUESTION: You said that, regarding the euro-dollar, you see volatility continuing in the near term. I was just wondering if you could be a little bit more precise on that and perhaps also elaborate a little bit on your reasoning.

MR. SWOBODA: Simply put, there are two types of exchange rate movements that we are concerned about; one is near-term, day-to-day, week-to-week, month-to-month, quarter-to-quarter fluctuations. I think these you would expect to be, on average, about the same in the near future than they have been in the past.

There are some factors, some uncertainties making for more volatility in the euro rate. Part of the reasoning would be to say that, as the euro area as a whole is a more closed area, you might expect the exchange rate to be more volatile than in the component currencies. In particular, this is because the ECB, will probably practice more benign neglect towards the euro rate than some of the individual component central banks would have.

To this, one can add that there are still some uncertainties as to the extent to which the euro will be used as a reserve instrument, what its role in trade denomination will be and so on, which creates an uncertainty.

On the other side of the balance, you could say, that the European Central Bank would, on average, demonstrate a more stable policy than some of the component central banks in the past. If we have rather more stable U.S. monetary policy in the current term, or more credibility in U.S. monetary policy than we had, say, 20 years ago, then that would make for greater exchange rate stability. So, on balance, there is no reason to expect a major change in that volatility.

MR. MUSSA: I would like to clarify something. I was listening to what Alex said, and I think, the way I remember the sentence, is you said, "Although there may be some issue of whether we have excessive depreciation of the euro at present." We would not, at this time, want U.S. monetary policy to ease and ECB policy to tighten in an effort to correct that.

QUESTION: Mr. Masson said that for those countries with larger trade with one of the major-currency countries, pegged rates are one of the things that they could do better. And in the case of Mexico, they have a large share of trade with the U.S., and since Mexico left behind the pegged-system in 1994, I was wondering if you foresee, in the short term, any chance that Mexico could go back to the pegged rate. Also, do you share some of the concerns of some Mexican economists who say that the peso is, at this time, overvalued?

MR. MASSON: I think there are several things that need to be noted: One is that Mexico has had a variety of exchange rate regimes. In a number of cases, supporting policies haven't been in place to make those regimes sustainable. I think one could very well imagine that a rate pegged to the U.S. dollar could be sustainable — as you note, there is an enormous amount of trade with the United States.

However, there are advantages to flexibility. The second thing I would note is that the current regime seems to be working rather well, and I would say that there's nothing in the immediate situation that would make one want to change that regime. And my understanding is that the authorities are moving towards something that would give somewhat more weight to inflation targeting in the formulation of monetary policy, and retaining a degree of flexibility for the exchange rate. I think that's a perfectly viable regime.

One could in other circumstances envisage a pegged rate to the U.S. dollar, but my personal view is that that's not very likely in the near future.

On the second questions, I don't have an estimate of the equilibrium value of the peso. I know that with some resumption of capital inflows, there has clearly been an upward movement in the nominal and the real value of the peso. But I'm not sure that we have yet entered the range where that's a major concern.

MR. MUSSA: I would discount the issue at this stage of a substantial overvaluation of the peso. If we look at the peso on an inflation-adjusted basis, using the consumer price index, it appears as if the peso has appreciated about to where it was before the late '94–'95 crisis. However, if we use unit labor costs, then we do not see that same degree of real appreciation. And Mexico's current account deficit is not nearly the size - 8% of gross domestic product — that it reached in 1994.

In addition, I think it is important to emphasize, and this is one of the virtues of the float, that it is a floating exchange rate, and the exchange rate floats up and it floats down. So if concerns were to arise about a rise in the current account deficit, the market would probably tend to push the peso down. And in this regard, Mexico is now much in the same situation that Canada is.

I would not, however, preclude that over the course of time there might be a meaningful adjustment of the peso. But it will depend on capital flows and a lot of other issues.

QUESTION: I wanted to ask you a bit more about some comments you made on Asian countries some way into the report. You talk about the possibility of some appreciation of some of these currencies and the temptation to stop that appreciation, a possible de facto picking of exchange rates, which could create the problems that led to the Asian Crisis. I'm wondering whether you could elaborate on what those problems you talk about would be, and how likely is that scenario?

MR. MUSSA: Well, of course, Malaysia has pegged the ringgit to the dollar at 3.80 to the dollar. So there, there definitely is a repegging. I think there is an issue of whether the ringgit is, in fact, undervalued at this stage, and I guess my judgment would be that it probably remains at least moderately undervalued. That undervaluation could become quite significant if we got a downward correction of the dollar against the euro, and perhaps, to some extent, also against the Japanese yen.

With respect to the other Asian currencies, they are formally floating, and they do move — have moved over the past year a fair bit in response to market forces.

We remain concerned, however, that if there was a return to de facto pegging of exchange rates, that this could recreate some of the same types of problems that we saw develop in the course of the Asian Crisis.

First, you start out with an exchange rate that's probably pegged too low. That makes you an attractive place for capital to flow in, in part to take advantage of investment in industries that can produce more competitively there than elsewhere. As capital flows in and you gain reserves, you try to sterilize the effect of that. But that cannot be completely effective, so you begin to get more domestic price inflation. And after a while, you get your exchange rate potentially overvalued, and then you may have considerable difficulties extricating yourself from that situation.

So it is important — and we emphasize this in the report — that if you have a floating exchange rate regime, that the exchange rate really does float in response to market forces, so that businesses, when they are trading — and particularly when they are borrowing, and lending, and engaging in capital market transactions — recognize that there really is foreign exchange risk. That is to say, the exchange rate will move, and that businesses do not have an implicit guarantee that the government will step in to rescue them in the event they make bad judgments about how to structure their businesses and their balance sheets.

QUESTION: A follow-up on the previous question. It seems that the peg system is favorable right now in Asia. But in China, for the first time in quite a while, in these few days we have seen a de facto devaluation of the renminbi. Is there any concern that there could be a chain reaction starting from too strong a fluctuation of the Chinese currency?

MR. MUSSA: I'm not aware of any effective devaluation of the renminbi. I don't know, Graham, have you?

MR. HACCHE: No.

MR. MUSSA: No, I don't think that that is factual. The Chinese government, of course, has been tightening some aspects of its capital controls regime in order to resist capital outflows for some time. But the current account remains in modest surplus. Over the course of the last 2 years, there has been deflation in China, and our analysis certainly does not suggest at this time that there is any significant overvaluation of the renminbi.

Now, we are also, I think, well past the Asian Crisis. I don't think one should preclude the possibility that at some point in the future the Chinese will make some adjustment in their exchange rate regime. I think, however, that it is incorrect to assume that were such an adjustment made, that it would have broadly destabilizing consequences.

When China unified its exchange rate regime in 1994, considerable adjustment occurred de facto because we had the split between the official market and the gray market exchange rates. But I would not anticipate an adjustment of anywhere near that magnitude, even if they moved to more flexibility at some point in the coming years.

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